Finding Late-Cycle Winners

As investors look for clues on market durability, our Chief U.S. Equity Strategist highlights which sectors could show more widely distributed gains in the near term.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about an opportunity for energy stocks to keep working in the near term.

It's Tuesday, March 26th at 9:30 am in New York. 

So let’s get after it.

Over the past five months, global stocks are up about 25 percent while many other asset prices were up double digits or more. What’s driving this appreciation? Many factors are at work. But for stock indices, it’s been mostly about easier financial conditions and higher valuations rather than improving fundamentals. Granted, higher asset prices often beget even higher prices – as investors feel compelled to participate. From our perspective, it’s hard to justify the higher index level valuations based on fundamentals alone, given that 2024 and 2025 earnings forecasts have barely budged over this time period.  

We rolled out our “Boom-Bust” thesis in 2020 based on the shift to fiscally dominant policy in response to the pandemic. At that point, our positive view on stocks was based on the boom in earnings that we expected over the 2020-2021 period as the economy roared back from pandemic lows. Our outlook anticipated both accelerating top line growth and massive operating leverage as companies could reduce headcount and other costs while people were locked down at home. The result was the fastest earnings growth in 30 years and record high margins and profitability. In other words, the boom in stocks was justified by the earnings boom that followed. Stock valuations were also supported by arguably the most generous monetary policy in history. The Fed continued Quantitative Easing throughout 2021, a year when S&P earnings grew 48 percent to an all-time high.

Today, stock valuations have reached similarly high levels achieved back in 2020 and [20]21 – in anticipation of improving growth after the earnings deterioration most companies saw last year. While the recent easing of financial conditions may foreshadow such an acceleration in earnings, bottom-up expectations for 2024 and [20]25 S&P 500 earnings remain flat post the Fed’s fourth quarter dovish shift. Meanwhile, small cap earnings estimates are down 10 percent and 7 percent for 2024 and [20]25, respectively since October. We think one reason for the muted earnings revisions since last fall, particularly in small caps, is the continued policy mix of heavy fiscal stimulus and tight front-end interest rates. We see this crowding out many companies and consumers.  

The question for investors at this stage is whether the market can finally broaden out in a more sustainable fashion. As we noted last week, we are starting to see breadth improve for several sectors. Looking forward, we believe a durable broadening comes down to whether other stocks and sectors can deliver on earnings growth. One sector showing strong breadth is Industrials, a classic late-cycle winner and a beneficiary of the major fiscal outlays for things like the Inflation Reduction and CHIPS Act, as well as the AI-driven data center buildout. 

A new sector displaying strong breadth is Energy, the best performer month-to-date but still lagging considerably since the October rally began. Taking the Fed’s recent messaging that they are less concerned about inflation or loosening financial conditions, commodity-oriented cyclicals and Energy in particular could be due for a catch-up. The sector’s relative performance versus the S&P 500 has lagged crude oil prices, and valuation still looks compelling. Relative earnings revisions appear to be inflecting as well. Some listeners may be surprised that Energy has contributed more to the change in S&P 500 earnings since the pandemic than any other sector. Yet it remains one of the cheapest and most under-owned areas of the market.  

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