The Mid Cycle Transition

As the weather chills and we head towards the end of the mid-cycle transition, the S&P 500 continues to avoid a correction. How long until equities markets cool off?

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 11th at 11:30 a.m. in New York. So, let's get after it.

With the turning of the calendar from summer to fall, we are treated with the best weather of the year - cool nights, warm days and clear skies. In contrast, the S&P 500 has become much more volatile and choppy than the steady pattern it enjoyed for most of the year. This makes sense as it's just catching up to the rotations and rolling corrections that have been going on under the surface. While the average stock has already experienced a 10-20% correction this year, the S&P 500 has avoided it, at least so far.

In our view, the S&P 500's more erratic behavior since the beginning of September coincided with the Fed's more aggressive pivot towards tapering of asset purchases. It also fits neatly with our mid-cycle transition narrative. In short, our Fire and Ice thesis is playing out. Rates are moving higher, both real and nominal, and that is weighing disproportionately on the Nasdaq and consequently the S&P 500, which is heavily weighted to these longer duration stocks. This is how the mid-cycle transition typically ends - multiples compressed for the quality stocks that lead during most of the transition. Once that de-rating is finished, we can move forward again in the bull market with improving breadth.

With the Fire outcome clearly playing out over the last month due to a more hawkish Fed and higher rates, the downside risk from here will depend on how much earnings growth cools off. Decelerating growth is normal during the mid-cycle transition. However, this time the deceleration in growth may be greater than normal, especially for earnings. First, the amplitude of this cycle has been much larger than average. The recession was the fastest and steepest on record. Meanwhile, the V-shaped recovery that followed was also a record in terms of speed and acceleration. Finally, as we argued last year, operating leverage would surprise on the upside in this recovery due to the unprecedented government support that acted like a direct subsidy to corporations.

Fast forward to today, and there is little doubt companies over earned in the first half of 2021. Furthermore, our analysis suggests those record earnings and margins have been extrapolated into forecasts, which is now a risk for stocks. The good news is that many stocks have already performed poorly over the past six months as the market recognized this risk. Valuations have come down in many cases, even though we see further valuation risk at the index level. The bad news is that earnings revisions and growth may actually decline for many companies. The primary culprits for these declines are threefold: payback in demand, rising costs, supply chain issues and taxes.

At the end of the day, forward earnings estimates will only outright decline if management teams reduce guidance, and most will resist it until they are forced to do it. We suspect many will blame costs and even sales shortfalls on supply constraints rather than demand, thereby giving investors an excuse to look through it. As for taxes, we continue to think what ultimately passes will amount to an approximate 5% hit to 2022 S&P 500 EPS forecasts. However, the delay in the infrastructure bill to later this year has likely delayed these adjustments to earnings.

The bottom line is that we are getting more confident earnings estimates will need to come down over the next several months, but we are uncertain about the timing. It could very well be right now as the third quarter earnings season brings enough margin pressure and supply chain disruption that companies decide to lower the bar. Conversely, it may take another few months to play out. Either way, we think the risk/reward still skews negatively over the next three months, even though the exact timing of cooler weather is unclear. Bottom line, one should stay more defensive in equity positioning until the winter arrives.

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