There is a ‘material risk’ to stocks as the bear market’s ‘second act’ looms

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Stock-market investors have been adjusting to the jump in interest rates amid high inflation, but they have yet to cope with profit headwinds faced by the S&P 500, according to Morgan Stanley Wealth Management.

“While a rate peak may solidify estimates for the equity risk premium and valuation multiples, equity investors still face the bear market’s second act — the earnings outlook,” said Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, in a note Monday. 

“They have been slow to recognize that pricing power and operating margins, which hit all-time highs in the past two years, are unsustainable,” she said. “Even without a recession, the mean reversion of profits in 2023 translates to a 10%-to-15% decline from current estimates.”

MORGAN STANLEY WEALTH MANAGEMENT NOTE DATED OCT. 17 2022

Unprecedented monetary and fiscal stimulus during the throes of the pandemic had led to the largest U.S. companies booking record operating margins that were 150 to 200 basis points above norms seen in the past decade, according to Shalett. 

See: Stock market’s wild gyrations put earnings in focus as inflation crushes Fed ‘pivot’ hopes

She said that company profits may now be imperiled by slowing growth, with “demand skewing toward services” after pulling forward toward goods earlier in the pandemic, and a likely reversal in “extremely strong” pricing power as the Fed fights surging inflation with interest-rate hikes.

“Such risks are not discounted in 2023 consensus yet, constituting a material risk to stocks for the remainder of the year,” Shalett said.

While many sectors have discounted the potential drop in 2023 profits from current estimates that could stir headwinds even with no recession, “the megacap secular growth stocks that dominate market-cap indexes have not,” she warned. “And those indexes are where risk gets repriced in the bear market’s final stages.”

Morgan Stanley’s chief U.S. equity strategist Mike Wilson estimates as much as 11% downside from consensus estimates, with his base-case, earnings-per-share forecast for the S&P 500 for 2023 being $212, according to Shalett’s note. 

U.S. stocks were bouncing Monday, with major stock benchmarks trading sharply higher in the afternoon, after sinking Friday amid inflation concerns as earnings season got under way. The S&P 500 SPX, +2.65% was up 2.7% in afternoon trading, while the Dow Jones Industrial Average DJIA, +1.87% gained 1.9% and the technology-heavy Nasdaq Composite surged 3.5%, FactSet data show, last check. 

In the bond market, Treasury rates were trading slightly lower Monday afternoon, after the 2-year yield hit a 15-year high and the 10-year yield notched a 14-year high on Friday, according to Dow Jones Market Data. Two-year yields ended last week at 4.507%, the highest level since August 8, 2007 based on 3 p.m. Eastern time levels, while the 10-year rate climbed to 4.005% for its highest rate since Oct. 15, 2008.

The yield on the 10-year Treasury note TMUBMUSD10Y, 4.015% was down about 1 basis point Monday afternoon at around 4%, while two-year yields TMUBMUSD02Y, 4.456% fell about five basis points to around 4.45%, FactSet data show, at last check.

Meanwhile, as investors capitulated to higher inflation, “peak policy rates moved up aggressively in the fed funds futures market, with the terminal rate now at nearly 5%, an aggressive stance that smacks of ‘peak hawkishness,’” according to the Morgan Stanley note.

“Critically, although the market is still pricing 1.5 cuts in 2023, the January 2024 fed-funds rate is estimated at 4.5%, a comfortable 100 basis points above our forecast” for core inflation measured by the consumer-price index, Shalett wrote.

“Consider locking in solid short-term yields in bonds and shoring up positions in high growth, dividend-paying stocks,” she said. “Short-duration Treasuries look attractive, especially because the yield is more than 2.5 times that of the dividend yield on the S&P 500.”

This article was originally published by Marketwatch.com. Read the original article here.

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