The Next Stage of the Market Correction

Is the end of the correction in sight? Our CIO and Chief U.S. Equity Strategist looks at what could bring this pullback to an end.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief U.S. Equity Strategist.

Is the end of this equity market correction in sight? Today on the podcast, I’ll share what I think could turn the tide.

It's Monday, October 26th at 11:30 am in New York.

So, let’s get after it

The correction that began in June is now well advanced beneath the surface. But I believe the high-quality S&P 500 index may still have some unfinished business. Until that plays out, I don’t think we can say the adjustment is complete.

The real question to ask: how bad does it have to get before it gets better?

We have described this correction as a classic mid-cycle transition. The peak rate of change in earnings revisions arrived right on schedule, about a year after the recession troughed. And the market responded the way that it usually does: early-cycle leaders with more operating and financial leverage started to underperform, while higher-quality, asset-light, services-oriented businesses moved to the front.

This quality rotation is now well understood though, and positioning has followed it. Ironically, the final step is usually a convergence between the resilient high quality S&P 500 index and the weaker breadth beneath. We may already be seeing the beginning of that meeting in the middle. If the index does move lower, I believe 7100-7200 on the S&P 500 is where the correction should find material support.

The reason I believe we will ultimately have a positive resolution to this transition is that a lot of damage has already occurred. Roughly 60 percent of Russell 3000 stocks are down more than 20 percent since June. And the hit has been even more severe in early-cycle areas like Semiconductors, Autos, Consumer Cyclicals, and Capital Goods.

At the same time, hedge-fund positioning has come down meaningfully leaving us near the lows for the past 12 months. That is encouraging, but sentiment overall is not yet at the kind of extreme that typically marks a durable low. I think we are close but we’re not quite there.

So, what gets us there? I see three clearing events ahead.

The first is AI. Investors are questioning the eventual return on capital, the cost of capital, and whether credit markets can fund all the spending that has been promised. Over the next few weeks, the market will need to absorb more supply, and lower-quality players may continue to see wider spreads and even lower stock prices.

I view the supply as the event itself. Once it clears, the risk should begin to fade. Semiconductors remain at the center of this concern, and may offer a good benchmark to monitor for the broader market correction. Specifically, I see another 10 to 15 percent lower for the Semiconductor index into mid-November.

The second clearing event is the midterm elections. Markets dislike uncertainty, and this election has plenty. A blue wave is not a surprise anymore though. The larger overhang is what may happen after the vote, including the possibility of a renewed military escalation in Iran.

I have no special edge in forecasting geopolitics. But I do know that these kinds of shocks often create very good buying opportunities. Historically, post-midterm returns have been very strong, so I would be ready to embrace a sharp downdraft in stocks in the days and weeks around election day.

The third, and most important, clearing event is liquidity. Financial conditions have tightened sharply through a combination of higher rates, slower balance-sheet growth, stronger demand for capital, and higher energy prices.

The tightening is beginning to resemble 2018, and it is not far from what we experienced in 2022 despite very modest tightening from the Fed so far. In fact, the market may be doing the Fed’s tightening for it; and if that tightening begins to create funding stress or destabilizes credit markets, the Fed and Treasury have tools to respond. The question is whether conditions need to deteriorate further before they act.

Bottom line, I think the correction in equity markets that began in June is in the final stages, but the final stage can be very uncomfortable. We may still need one more index-level drawdown and bout of volatility. Or one more moment when investors conclude that something has broken. That may be exactly what clears the path for the Fed to pivot and the next leg higher for stocks.

For now, I want to stay with quality stocks that have already corrected more than the index in areas like capital goods. More importantly, if these clearing events create a sharp downdraft, I would view it less as a reason to run from risk and more as the opportunity we have been waiting for to buy. So be ready.

Thanks for tuning in; I hope you found it informative and useful. Let us know what you think by leaving us a review. And if you find Thoughts on the Market worthwhile, tell a friend or colleague to try it out!