An earnings recession is still to come, and it will be worse than anyone thinks, Morgan Stanley said in a new note to clients.
The company expects a “meaningful” slump in earnings this year, with profits falling 16% by the end of the year before seeing a “sharp recovery” in 2024.
“The path to earnings out of consensus is supported by our models and our view that policy will become more appropriate in 2024, not 2023,” writes Michael Wilson, chief investment officer at Morgan Stanley. “It is also supported by our hypothesis that we are in the midst of several ‘hotter but shorter’ earnings cycles within the context of a broader secular bull market (the ‘boom/crash/boom’ system).”
Wilson and his team still see the S&P 500 falling from its current levels, which is currently up about 20% from the October 2022 low. The general belief is that the S&P 500 will drop to 3900 by the end of the year, and the S&P 500 will produce earnings per share. valued at $185. According to the company, Morgan Stanley’s 2023 earnings per share target for the S&P 500, revised down from $195 today, is 17% below the market consensus.
Morgan Stanley is not alone in saying things are getting a little rosy for stocks. Earnings of S&P 500 companies are down year-over-year for two quarters in a row now, According to Facttest. Analysis from Bespoke Investment Group shows that investors haven’t bet so heavily on a decline in the S&P 500 since 2007. Economists continue to warn of an economic slowdown whether or not the Federal Reserve continues to raise interest rates.
All the while, stocks have rallied, with the Nasdaq now up nearly 10% in the past month. The forward price-to-earnings ratio for the S&P 500 is now in the top 20% of historical levels dating back to the 1980s, according to Morgan Stanley. AI-focused names such as Nvidia (NVDA), Marvell Technology (MRVL), and more recently MongoDB (MDB) have risen after positive comments on the possibilities of AI in their businesses.
While Morgan Stanley’s equity team isn’t generally buying technology, it’s not buying a seat on the AI hype train to lead investors to new market highs in 2023.
“While there will undoubtedly be individual stocks seeing exponential growth from AI spending this year, we don’t think it will be enough to change the overall trend of cyclical earnings in a meaningful way as the top line slows and cost pressures remain constant,” Wilson wrote. We are now out of consensus on our earnings view.”
“In fact, the only other times that the difference between our earnings model and the consensus has been this large were in August 2008 and late 2001, both of which are very risky periods for the stock.”
Where to hide from the “Bear League”
While Wilson and his team still see a broader secular bull market, they believe a cyclical bear market is coming. A bear market comes into play as markets very quickly lose sight of the late effects of a rising interest rate environment.
Morgan Stanley likens the surge in stocks throughout 2021 and then the subsequent crash in 2022 to the aftermath of World War II when the economy was also struggling, as now, to manage excess savings and keep prices down.
And that will lead to a tactical correction in some stocks, the narrowly-pushed S&P 500 index, which is up again in 2023, argues Morgan Stanley.
When that happens, the trajectory will be something like this: Fed policy will become more growth-friendly, but that will come with rate cuts in 2024, not late 2023. as the futures markets currently indicate can happen.
In this case, Morgan Stanley likes “traditional defensive areas” like consumer commodities and health facilities.
“We prefer a defensive positioning of the challenging earnings environment that we expect to continue and a search for sectors and industry groups that have a reliable track record of outperforming late in the cycle/during an earnings slump,” Wilson wrote.
Josh is Yahoo Finance Correspondent.
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