As the S&P 500 continues to rally, our CIO and Chief U.S.
Equity Strategist Mike Wilson discusses three factors that could
lead to a stock market correction in the near term.
Read more insights from Morgan Stanley.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan
Stanley's CIO and Chief U.S. Equity Strategist. Today on the
podcast I'll be discussing why we are still in a new bull market
even if a correction is likely in the near term.
It's Monday, October 20th at 1pm in New York.
So, let's get after it.
I continue to believe the sharp selloff in April following
Liberation Day marked the trough of what was effectively a
three-year rolling recession in the U.S. economy. We have written
extensively about this view; but it still remains very much out
of consensus.
Since 2022 most sectors of the private economy have gone through
their own individual recession but at different times. The final
trough in the rate of change in economic activity came in
April around the tariff announcements which came as a
surprise to almost everyone, at least in terms of the magnitude
and scope.
In short, Liberation Day was really capitulation day on the last
piece of bad news for the economic cycle which then
bottomed.
Stocks seem to agree which is why they have rallied in a straight
line since then, much like they do after the trough in any
economic cycle. The other proof we have for this claim is the
v-shaped recovery in earnings revision breadth, something we have
discussed for many months in our written research and on this
podcast.
Based on our numerous conversations with investors, this view
remains very unpopular. Instead, most believe the economy and
earnings growth for next year are at risk of being lower rather
than higher than expected, as I do. Core to my view is that we
are now firmly in an inflationary regime since COVID and the
implementation of helicopter money to get us out of that crisis.
The government has to run it hot to get us out of
the massive debt and deficit problem created over the past 20
years.
The end result is that investors need to expect hotter but
shorter cycles rather than the elongated 10-year cycles we
experienced between 1980-2020 when inflation was falling. That
means two-year up cycles followed by one-year down cycles for
U.S. equity markets, which is exactly what's happened since
2020.
We are now in the midst of a new up cycle that began in April.
The key thing to understand during this new regime is that
inflation is not bad for stocks so long as it's accelerating and
the Fed is on the sidelines or easing like in 2020-21, 2023 and
now today. Higher inflation means higher earnings growth which is
why price earnings multiples are high today. With inflation
likely to accelerate next year, stocks are anticipating better
earnings growth.
In other words, stocks are a hedge against inflation. In fact,
relative to gold, high quality stocks may offer a cheaper
inflation hedge at this point given their dramatic
underperformance to precious metals year-to-date and since
2021.
Eventually, inflation will be a problem again for stocks like in
2022 when the Fed has to react by tightening policy, but that's a
story for another day.
Having said all this, the equity markets are a bit frothy at the
moment and so a 10-15 percent correction in the S&P 500 is
not only possible but would be normal at this stage of a new bull
market. I see three primary reasons for why we could
get that in the near term.
First, China-U.S. trade relations have recently escalated again,
and we are slowly marching toward a November 1st deadline for
tariffs on China to go back to Liberation Day levels. While most
investors don't want to get sucked into selling at the worst
possible time like they did in April, this risk is real and will
weigh on stocks if we don't see evidence of a de-escalation in
the next few weeks.
Second, funding markets have exhibited some signs of increased
stress lately. This is likely due to the ongoing quantitative
tightening program by the Fed which is draining bank reserves.
Should these stresses increase, it could spill over into
equities.
Third, our earnings revision breadth metric is rolling over now
after its historic rise since April. This could continue into
earnings season as it's normal to see some retracement from such
a high level and tariffs start to flow through from inventories
to the income statement. Trade tensions might also weigh on
company guidance in the short term.
Bottom line, I believe a new bull market began in April with a
new rolling economic and earnings recovery that is now quite
nascent. However, even new bull markets have corrections along
the way, and certain conditions argue we are at risk for the
first tradable one since April.
Keep your powder dry in the near term for what should be a great
buying opportunity, if it arrives.
Thanks for tuning in; I hope you found it informative and useful.
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