The market rally has assuredly been more powerful than Morgan Stanley had anticipated, defying the weak fundamentals. Many have said they don’t think fundamentals will matter for the rest of this year. We have seen earnings estimates for the S&P500 decline recently, with notable pre-releases from Intel, FedEx, and Burberry among others, a rash of weak recent economic data including ISM and the underlying inventory build, jobs, PPI, industrial production, and the beginning of softer consumption on the consumer side after a strong August. Yet, the S&P total return index is at an all-time high. People can’t envision a catalyst to make fundamentals matter, they can’t envision a catalyst for earnings to come down, and they still think the “tradable rally” from positioning and policy will last. It well may last for a while more, but the disconnect from fundamentals can’t last forever.
Via Morgan Stanley's Adam Parker: Behavioral Economics 101
Why were sales traders cheering a bad job report Friday before last? Because they were ready for another Pavlovian risk-on trade higher, and from all accounts they are getting what they wanted. We understand that, and we get that there can be a self-fulfilling prophecy, or “tradable” rally. We admit we were too dismissive of this mindset the past few weeks. We hope we learned the lesson for the future, but we’re not sure we’re that smart, so we will see. The question we try to ask ourselves when we walk in the office is, “Do we like stocks more today than we did a few weeks ago?” Every ounce of our experience says that we shouldn’t. Why? Because our view of earnings is not better, the consensus view of earnings is too high, and the market is materially higher than it was only a few weeks ago. Discipline says, no matter what the starting point, you should like things less now than you did then. We all know that the current “bad is good, good is good” mentality can’t persist. We all know that at some point, whether it is in a few days, weeks, or even months, the market will shift to a “bad is bad, and good is bad” psychology. It’s behavioral sciences 101. It always happens that way.
When will fundamentals matter again? We don’t know. Our guess is sometime between October earnings season and right after the US Presidential election. If not, our view that the market’s next double-digit move is down, not up, will be wrong by year-end, and we will have to moderate our stance or push out the timing of our expectations. We use a framework to establish our market view. The framework says earnings will be $99 for the S&P500, not the consensus view of $116. The framework also says that low and volatile earnings growth (S&P500 earnings grew roughly 0% quarter over quarter in the July quarter and are forecasted to decline both year-over-year and sequentially in the October quarter) and extreme interest rates are bad for multiples. Our conviction on our EPS outlook remains reasonably high today. Our conviction on the relevancy of the framework for market multiples over the next three months is clearly the issue at hand.
We don’t do heroin. We are sure the period of being high on heroin is “enjoyable.” Even one light beer is a mood enhancer for us. However, we try to see through to the other side of it and make a judgment that injecting heroin into our arms is not a good idea. What’s our point? We think the probability that we can end up in a benign interest rate environment goes down every time the Fed does more unconventional policy. That’s why it is called unconventional. We had thought that most investors would decide this “heroin” wasn’t worth it. We forgot about what it means to be an addict. We were wrong and clearly mis-calibrated the strike price of the Fed “put”. Maybe not ultimately wrong, and maybe not even by year-end, but for sure over the past few months we were wrong about the demand for this kind of artificial stimulus. We should have known when the economic data were clearly weaker and corporate profits plummeted during pre-release season in June and July that the market rally was about the promise of more unconventional policy. The central debate remains the same, though. Will equities continue to go higher simply because the specter of unlimited liquidity is there or will investors see through to the other side of the “high” and worry that we are going to be in an extreme interest rate environment for a while and that earnings growth will remain tepid? Often addicts know what they’re doing is wrong, but they do it anyway.
Manhattan is crowded. In our judgment, sentiment is decidedly bullish. Decidedly – both on the earnings outlook and the equity market. We know everyone likes to romanticize that they are a contrarian bull on an island by themselves, but trust us, that island is not vacant. It’s crowded. Like Manhattan crowded. (Actually, we just looked it up, and Manhattan, by density, is only the 13th most dense city on earth. Chennai, India is #1. This worldwide web thing is cool.) We have received several emails in the last week from investors with messages of the ilk that “we all know this will end in tears”, but for now, people are not at the rehab center.
People can’t envision a catalyst to make fundamentals matter, they can’t envision a catalyst for earnings to come down, and they still think the “tradable rally” from positioning and policy will last. It well may last for a while more, but the disconnect from fundamentals can’t last forever.