Last week's September inflation data brought a subsequent rally in stocks, but can this rally hold while the bond market continues to follow the Fed?
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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 17th, at 1 p.m. in New York. So, let's get after it.
No rest for the weary as days feel like weeks and weeks feel like months in terms of price action in the financial markets. While there's always a lot going on and worth analyzing, it's fair to say last week was always going to be about the September inflation data one way or another.
From our vantage point, inflation has peaked. While 8% is hardly a rate the Fed can live with, the seeds have been sown for lower prices in many goods and services. Housing is at a standstill, commodity prices have fallen substantially since April, and inventory is starting to balloon at many companies at a time when demand is falling. That means discounting should be pervasive this holiday shopping season. Finally, the comparisons get much more challenging next year, which should bring the rate of change on inflation down substantially on a year-over-year basis.
At the end of last year, the bond market may have looked to be the most mispriced market in the world. That underpricing of inflation and rates was a direct result of Fed guidance. Recall that last December the Fed was suggesting they would only hike 50 basis points in 2022. More surprisingly, the bond market bought it and ten-year yields closed out the year at just 1.5%. Fast forward to today and we think the bond market is likely making the same mistake but on the other side.
We think inflation is peaking, as I mentioned, and we think it falls sharply next year. Shouldn't the rates market begin to ignore Fed guidance and discount that? We can't be sure, but if rates do fall under that premise, it will give legs to the rally in stocks that began last Thursday. As we have been noting in our last few podcasts, the downside destination of earnings-per-share forecasts for next year is becoming more clear, but the path remains very uncertain. More specifically, we're becoming skeptical this quarter will bring enough earnings capitulation from companies on next year's numbers for the final price lows of this bear market to happen now. Instead, we think it may be the fourth quarter reporting season that brings the formal 2023 guidance disappointment.
So how far can this rally in stocks run? We think 4000 on the S&P 500 is a good guess and we would not rule out another attempt to retake the 200-day moving average, which is about 4150. While that seems like an awfully big move, it would be in line with bear market rallies this year and prior ones. The other factor we have to respect is the technicals. As noted two weeks ago, the 200-week moving average is a formidable level for the S&P 500 that's hard to take out without a fight. In fact, it usually takes a full-blown recession, which we do not yet have.
Bottom line, we think a tradable bear market rally has begun last Thursday. However, we also believe the 200-week moving average will eventually give way, like it typically does when earnings forecasts fall by 20%+. The final price lows for this bear are likely to be closer to 3000-3200 when companies capitulate and guide 2023 forecasts lower during the fourth quarter earnings season that's in January and February.
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