The Fed's Negative Operating Leverage Thing Is Playing Out

After the events of the past few weeks, earnings estimates look increasingly unrealistic and the bear market may finally be ready to appropriately factor-in elevated earning risks.

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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, March 27th at 11 a.m. in New York. So let's get after it. 

Back in October, when we turned tactically bullish, we wrote that markets often need the engraved invitation from a higher power to tell them what's really going on. For bond markets, that higher power is the Fed, and for stocks it's company earnings guidance. 

Our assumption at the time was that we were unlikely to get the negative messaging on earnings from companies necessary for the final bear market low. Instead, our view is that it would likely take another quarter for business conditions to deteriorate enough for companies to finally change their minds on the recovery that is still baked into consensus forecasts. 

Fast forward to today and we are seeing yet another quarter where estimates are being lowered to the same degree we have witnessed over the past two. In other words, it doesn't appear that the earnings picture is bottoming as many investors were starting to think last month. In fact, these downward revisions are progressing right in line with our earnings model, that suggests bottoms up estimates remain 15 to 20% too high. 

More specifically, consensus estimates still assume a strong recovery in profitability. This flies directly in the face of our negative operating leverage thesis that is playing out. Our contention that inflation increases operating leverage and operating leverage cuts both ways, is a concept that is still under appreciated. We think that helps to explain why we are so far below the consensus now on earnings. More importantly, it doesn't necessarily require an economic recession to play out, although that risk is more elevated too. 

This leads us to the main point of this week's podcast. With the events of the past few weeks, we think it's becoming more obvious that earnings estimates are unrealistic. As we have said, most bear markets end with some kind of an event that is just too significant to ignore any longer. We think recent banking stress and the effects they are likely to have on credit availability is a risk that the market must consider and price more appropriately. 

Three weeks ago, the bond market did a striking reversal that caught many market participants flat footed. In short, the bond market appeared to have decided that the recent bank failures were the beginning of the end for this cycle. More specifically, the yield curve bull steepened by 60 basis points in a matter of days. Importantly, it was the first time we can remember the bond market trading this far away from the Fed's dot-plot. It was dismissing the higher powers guidance. We think this is important because now in our view it's likely to be the stock market's turn to think for itself, too. 

To date, the bear market has been driven almost entirely by higher interest rates and the impact that it has had on valuations. More specifically, when the bear market started, the price earnings multiple was 21.5x versus today's 17.5x. Importantly, this multiple troughed at 15.5x in mid-October, the lows of this bear market to date. Well, that's a relatively attractive multiple and one of the reasons we turned tactically bullish at the time, we think it never reflected the growth concerns that should now dominate the market and investor sentiment. Our evidence for that claim is based on the fact that the equity risk premium is actually lower by 110 basis points than it was at the start of this bear market. In other words, the portion of the price earnings multiple related to growth expectations is far from flashing concern. Based on our analysis, the equity risk premium is approximately 150 to 200 basis points too low, which translates into stock prices that are 15 to 20% lower at the index level. The good news is that the average stock is getting cheaper as small cap stocks have underperformed, along with banks and other areas most affected by recent events. Areas that appear most vulnerable to the further correction we expect include technology, consumer goods and services and industrials. Remain patient until the market has appropriately discounted the earnings risk that we think has moved center stage. 

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