“The Rolling Bear Market Is Now Complete”: Most Bearish Analyst Turns Bullish… But There’s A Catch
It took Wall Street and markets about 12 months to admit that Morgan Stanley’s Michael Wilson, who for a long time was the most bearish sellside strategist, was correct with his gloomy S&P forecast at a time when his peers were scrambling to come up with the highest possible, and incorrect, 2018 year end S&P price target. And just as Wall Street was well behind the curve on the way down, it will likely be chasing Wilson – who dubbed the term “rolling bear market” to describe market action for much of 2018 – as he sheds his bearish aura and turns at least modestly bullish.
In a note released early on Monday, the Morgan Stanley analyst notes that while the rolling bear market narrative has described the past year well “with virtually every asset class in the world derating significantly” as shown in the chart below…
… He is now comfortable saying that “the rolling bear market is now complete at the index and sector level” however, he still thinks that there is idiosyncratic risk at the stock level for valuations to come down further or earnings to be cut more than what is already priced.
One such example is, of course, Apple and Wilson suspects that there are more “Apples” looming out there as we enter 4Q earnings season; but while the Morgan Stanley strategist remains convinced that more single-name tape bombs are coming, he admits that “it’s difficult to ascertain exactly where those risks are the greatest.” His advice on how to find the next stock fiasco: “valuation matters again, so make sure you aren’t overpaying for stocks you own or want to buy (even if you think the quarter will be good).”
With that caution in mind, Wilson also concedes that “many of the things we (and the market) have been worried about have yet to be fully revealed”, however in the context of December’s violent repricing in the S&P and the volatile end to 2018, Wilson finds himself “contemplating if our concerns have been priced.”
There’s more: Wilson reveals his bullish reversal, noting that “the equity risk premium has expanded to levels not witnessed since early 2016″…
… and “the bottom line is that valuations have reached an attractive level at the index level for the first time in years” and adds that his bear case of 2400 was tested in December as markets began to discount our earnings recession call for 2019 “an outcome we still think has a 50% probability of occurring.”
What this means is that we like the S&P 500 at current levels for the those with a 12-month horizon, but we think there is a good chance we test or break recent lows as we experience a rolling bottom for individual stocks, particularly those that have high index weightings.
As a result, Wilson is clearly more constructive than has has been in over a year “based on valuation, sentiment, and positioning” but in light of the comments above, he still doesn’t think it is time to blow the all clear signal yet. Indeed, before making the call for the market “to move sustainably higher”, Morgan Stanley thinks there are still a few more hurdles to clear, “meaning, we doubt that the overall market is heading straight up from here.”
First, the technical damage is significant and there is quite a bit of overhead resistance that will need to be worked through.
Second, financial conditions are still tightening despite the Fed’s more dovish tone. Until they actually stop raising rates and/or reducing the balance sheet, we believe it will be hard to sustain a rally much above the old support of 2600-2650.
Finally, the negative news that we and the market have been worried about for the past 6 months is just starting to trickle out now. The weak manufacturing PMI and earnings miss from Apple are likely to be followed by more negative surprises over the next month. The end result is that earnings revisions for the S&P 500 will likely stay negative until they reach levels seen in 2016; and the stock market typically bottoms coincidentally with the rate of change on earnings revision breadth.
Ultimately, the bank – which previously hedged its bearishness in that it sees the poor performance of 2018 as a mini-bear within a secular bull – expects a very important cyclical low to this bear market to be put in this year and also expects a reversal of its Rolling Bear Market to occur in a First-in, First-out (FIFO) manner with the weakest links bottoming first and leading.
Finally, looking ahead, Wilson reiterates his 2750 S&P price target, which he sees as the mid point of a range bound market over the next year, adding that “the index will trade between our bear and bull cases, 2400 and 3000, during the year.”
To those curious how to trade this bullish reversal, Wilson says that “cyclicals should lead the way once the market finally troughs.” As the strategist says, what caught Wilson’s eye on the first few trading days of the year was that deeply cyclical sectors and stocks outperformed, and have continued to do so since the “Christmas Eve Massacre.” This internal relative strength of Cyclicals versus Defensives is supportive of the bank’s view that “we are actually getting closer to a trough, just as the consensus is finally recognizing that growth may be slowing more than they thought.”
This is a positive development and supports our preference for Value over Growth and our overweight in Cyclicals like Financials and Energy. Exhibit 5 is a reprint of a chart we showed in our last note of 2018. It clearly shows that the cyclicals have already discounted a much more severe deceleration in global nominal GDP growth than what our economists expect. On the other hand, it’s not discounting a 2015-16 downswing yet, but we don’t think the slowdown will be that bad. In other words, we have reached a spot where you need to be buying the Cyclicals and lightening up on the Defensives and overpriced Growth stocks
Finally, one other potential risk that may spoil this bullish reversal is that “a key part of our 2019 call is elevated risk of an earnings recession” as Morgan Stanley expects topline growth to decelerate (due to decelerating GDP) and pressure on margins. The market is increasingly pricing this risk as estimates have begun to fall.
Morgan Stanley’s bottom line: “the overall market will have a hard time bottoming until the earnings revision breadth bottoms. This will likely keep things choppy and volatile and may even lead to an eventual re-test and break of the lows we saw on December 24th.“
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