The stock market is on the verge of a correction, according to Morgan Stanley (MS, Financial) chief U.S. equity strategist Mike Wilson. He also believes investors should invest in low volatility stocks because of this expected correction and has assigned a year-end target of 4,000 for the S&P 500 Index, which implies a 10% decline from the current levels.
Joining the Thoughts on Markets podcast on Aug. 16, Wilson said:
“The combination of lower than consensus earnings next year and lower valuation leads us to believe there is very little upside, if any, to major U.S. equity indices over the next few quarters. In fact, our S&P 500 target price for year end is 4000, which is 10% below current levels. Between here and there, we expect a greater than 10% correction. More positively, such a correction would complete the mid-cycle transition we've been going through since mid-March and allow for the next leg of the economic expansion and bull market. Until then, investors should position a bit more defensively within their equity portfolios, favoring quality names in the health care, consumer staples, and utility sectors. We would pair it with financials which remain a good way to maintain exposure to higher inflation and interest rates as the Fed tapers its asset purchases. Importantly, valuation for financials remains attractive and earnings forecasts were reduced during the second quarter, meaning there is less risk of a disappointment.”
Morgan Stanley raised its S&P 500 earnings forecast for 2021 to $205 per share after a robust second-quarter earnings season. However, the company is less optimistic about earnings growth in 2022 due to many reasons, including a payback in demand and profitability, an increase in the corporate tax rate and the Federal Reserve's likely reduction in the size of its asset purchase program, all of which will put downward pressure on equity valuations.
Fiscal and monetary policy support played a massive role in strong earnings
Although the economy is recovering, analysts feel that stocks are getting ahead of the companies at the moment. Wilson believes there will be a potential payback on demand from last year's increase in spending resulting from the U.S. government's enormous fiscal stimulus that injected trillions of dollars into the economy.
This is not the first time a Morgan Stanley analyst has forewarned investors about the possibility of a market correction this year. Last July, Wilson said:
“In the absence of another stimulus, it seems likely growth will decelerate sharply and even disappoint what are now very high expectations, especially in areas like consumer discretionary and technology.”
Wilson also highlighted that following a recession, analyst projections become unduly pessimistic and prove simple for companies to beat when the economy rebounds. S&P 500 companies surpassed consensus earnings estimates by more than 15%, on average, in the second quarter, and it would be reasonable to believe that low estimates played their part this time around as well.
Considering how companies are returning to profitability at an extraordinary pace, Wilson said:
“The primary driver of the upside is operating leverage as revenues return to pre-recession levels before costs are layered back in. That was our view a year ago and this time is no different. In fact, the operating leverage was even more extreme than normal due to the extraordinary government support of those individuals who lost their jobs during the pandemic. Normally such a dramatic decline in employment would lead to significant declines in economic and sales growth. Instead, the stimulus packages and digital infrastructure allowed consumers to keep spending at a high rate. In fact, consumption never really declined that much and made new highs within just a few quarters of the recession trough. Meanwhile, companies cut costs and employment to the bone in anticipation of a major slowdown. The result has been predictable - an incredibly fast return to record profits and profitability that now look unsustainable.”
According to Morgan Stanley's Stock Market Outlook report for 2021, companies that were hardest hit by the virus-induced recession such as banks, movie theatres and cruise operators may present a compelling opportunity in the second half of this year, especially given the continued strength in consumer spending.
Notes on inflation
At a recent Fed meeting, Fed Chairman Jerome Powell suggested inflation could run much higher than what he initially predicted, and said:
“As the reopening continues, shifts in demand can be large and rapid and bottlenecks, hiring difficulties, and other constraints could continue to limit how quickly supply can adjust, raising the possibility that inflation could turn out to be higher and more persistent than we expect.”
The Federal Reserve now anticipates inflation to reach 3.4% this year, up from its prior forecast of 2.4%, and has also increased its PCE inflation forecasts for 2022 and 2023, with core PCE inflation estimated to hit 3% in 2021, up from 2.2% previously. Core PCE is predicted to be 2.1% in 2022, and it is expected to stay at a similar range in 2023.
Last June, Moody’s analyst Mark Zandi said in an interview:
“The headwinds are building for the equity market. The Federal Reserve has got to switch gears here because the economy is so strong.”
During the second-quarter earnings season, many companies warned of higher costs as well. If supply-side pressures forcing input costs to rise do not reduce as quickly as investors expect, markets will inevitably suffer in the remainder of the year.
Tapering is in the cards
Although the Fed did not provide any information regarding its bond-buying program, experts believe the Fed might begin tapering before the end of 2021 or in early 2022. As the labor market has not recovered fully, the Fed has delayed stating when it will stop buying bonds in the market. However, Powell said that policymakers considered the economy's progress to cut back on aggressive asset purchase programs and concluded that present conditions are far from ideal to limit its support to the economy. Commenting on this decision, Powell said:
“While reaching the standard of ‘substantial further progress’ is still a ways off, participants expect that progress will continue. In coming meetings, the committee will continue to assess the economy’s progress toward our goals. As we have said, we will provide advance notice before announcing any decision to make changes to our purchases.”
Given the pace of economic recovery, it's reasonable to anticipate the Fed to change its stance in the coming quarterly meetings. Tapering of bond purchases restricts the money supply, and once the Fed's purchases reach zero, policymakers will move on to increase policy rates, which could lead to a sharp decline in stock prices.
Takeaway
Even though the factors discussed here might have a significant impact on the S&P 500 in the short term, there’s reason to believe that a correction will pave the way for the next leg of the current bull market as the economy can only strengthen from the current levels. Wilson shares the same belief as well. Commenting on how investors can prepare for the upcoming correction, he said:
“Investors should position a bit more defensively within their equity portfolios, favoring quality names in the health care, consumer staples, and utility sectors. We would pair it with financials which remain a good way to maintain exposure to higher inflation and interest rates as the Fed tapers its asset purchases. Importantly, valuation for financials remains attractive and earnings forecasts were reduced during the second quarter, meaning there is less risk of a disappointment.”
Investing in companies with a strong liquidity position will be key to success in the next couple of years, and long-term-oriented investors should prepare to make the most of the opportunities that would be available if stocks pull back from historic highs.
