Mike Wilson: The Confounding Bear Market

Talk of recession continues among investors and consumers alike, but last week saw a sharp rally in U.S. Equities. Is this just a blip or could U.S. equity markets rally further?

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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, June 27th, at 2 p.m. in New York. So let's get after it.

With talk of recession increasing sharply over the past few weeks, equity markets decided enough bad news had been priced and rallied sharply. Furthermore, the decline in both oil and interest rates helped ease some of the concerns on inflation. In our view, both the fall in oil and rates are being driven more by fears of an economic slowdown rather than a real peak in inflation and will lead to a more dovish Fed. However, with markets so oversold and bearishness pervasive, equity investors have taken the bullish view and rerated stocks higher.

Based on Friday's close, the S&P 500 is trading back at 16.3 times, or one turn higher than where it was at the prior week's lows. This seems unusual given the growing concern about earnings, however. In fact, even taking into account the fall in 10-year yields, the equity risk premium is back below 300 basis points. In our view, that makes little sense in the context of the likely negative earnings revisions coming in the second quarter reporting season and the rising risk of recession over the next 6 to 12 months.

Perhaps the best way to explain last week's rally has to do with the short-term rolling correlation between equities and real yields, which is now deeply negative again. This means the recent decline in bond yields has been perceived as positive for equities, something we think will prove to be incorrect if the falling yields are signaling slower growth or recession. For falling yields to be positive for equities at this stage, we would need to see cresting inflation pressures, a less hawkish Fed policy path, more durable economic growth than we expect, and a reacceleration in earnings revisions.

In addition to this combination of factors, which suggests a soft landing for the economy, we would also need to see limited negative revisions to earnings. Thus, we see the recent rebound in equities as another bear market rally on the path to fair value price levels of 3400-3500 in the case a soft landing is achieved with modest earnings revisions. However, as noted last week, a recession would bring tactical price lows closer to 3000 as earnings decline by at least 20% before working back to our June 2023 bear case target of 3350. In short, the bear market is likely not over, although it may feel like it over the next few weeks. Markets are likely to take the lower rates as a sign the Fed can orchestrate a soft landing and prevent a meaningful revision to earnings forecasts.

In that context, we think U.S. equity markets can rally further. In addition to lower rates and oil prices helping support the belief in a soft landing there is some equity demand from pension funds that need to rebalance at the end of the month and quarter this week. If retail investors join in like last week, that could carry equity prices higher before second quarter earnings season begins and the revisions arrive. Finally, a retracement of 38-50% of the entire decline would not be unnatural or out of line with prior bear market rallies, even ones associated with a recession at the end. In S&P 500 terms, that would translate into 4100-4200 or approximately 5-7% upside from Friday's close. Furthermore, if such a rally were to continue, it would likely be led by the longer duration or interest rate sensitive stocks like technology, or the Nasdaq.

However, we want to be clear that in no way are we suggesting the bear market is over or that earnings estimates won't have to come down. Instead, we are simply being realistic about the nature of bear markets and their ability to confound all market participants at times, even the bears. We suggest using equity market strength over the next few weeks to lighten up further on portfolios.

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