Last week stocks rallied quickly but dropped just as fast as markets continue to hope for a more dovish Fed, but will this 2-way risk continue as evidence for a drop in earnings continues to accumulate?
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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 10th, at 1:30 p.m. in New York. So let's get after it.
Last week started with one of the biggest 2 day rallies in history, only to give most of it back by Friday's close. The culprit for this higher 2-way volatility is a combination of deteriorating fundamentals with oversold technicals. As noted last week, September was one of the worst months in what's been a difficult year, and the equity market was primed for a rally, especially with the S&P 500 closing right at its 200 week moving average on the prior Friday. Low quality stocks led the rally as further evidence the rebound was just bear market action rather than the beginning of a new bull. There is also still lingering hope for a Fed pivot, but the economic data that matters the most for such a pivot, jobs and inflation, continue to dash any hopes for a more dovish Fed.
The sellout of momentum and retail, to some degree, does keep 2-way risk alive in the short term as it gets quiet for the next few weeks on the earnings front. Over the past month, there has been evidence that our call for lower earnings next year is coming to fruition. Large, important companies across a wide swath of industries have either reported or preannounced earnings and guided significantly lower for the fourth quarter. Some of these misses were as much as 30%, which is exactly what's needed for next year's estimates to finally take the step function lower, we think is necessary for the bear market to be over. The question is, will enough of this happen during third quarter earnings season, or will we need to wait for fourth quarter reporting in January and February when companies tend to formally guide for the next year? We think the evidence is already there and should be strong enough for this quarter for bottoms up consensus estimates have finally come down to reality, but we just don't know for sure. Therefore, over the next two weeks, stocks could continue to exhibit 2-way risk and defend that 200 week moving average at around 3600.
One interesting development that supports our less optimistic view on 2023 earnings is in the dividend futures market. More specifically, we've noticed that dividend futures have traded materially lower, even as forward earnings per share forecasts have remained sticky to the upside. One reason this might be happening now is that cash flows are weakening. This is tied to the lower quality earnings per share we predicted earlier this year as companies struggled with the timing and costs versus revenues as the economy fully reopened. Things like inventory, labor costs and other latent expenses are wreaking havoc on cash flow. Accrual accounting earnings per share will likely follow 6 to 12 months later. In short, it's just another sign that our materially lower than consensus earnings per share forecasts next year are likely to be correct. If anything, we are now leaning more toward our bear case on S&P 500 earnings per share for next year, which is $190. The consensus is at $238.
Bottom line, the valuation compression in equity markets this year is due to interest rates rising rather than concern about growth. This is evidenced by the very low equity risk premium, currently 260 basis points, that we still observe. The bear market will not be over until either earnings per share forecasts are more in line with our view, or the valuation better reflects the risk via the equity risk premium channel. Bear markets are about price and time, price takes your money, time takes your patience. Let the market wear everybody else out. When nobody is calling for the bottom, you will then know it's finally time to step in.
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