“Wall Street’s tentative approach to earnings reviews creates risks” for the already expensive US stock market, according to the chief investment officer of Morgan Stanley’s wealth management business.
Consensus earnings forecast for the S&P 500 in 2023 fell to $230 per share, “down just $10″ despite aggressive monetary tightening from the Federal Reserve as it tries to rein in high inflation, guidance” increasingly negative” from corporate executives and signs of economic weakness, Lisa Shalett, CIO of Morgan Stanley Wealth Management, said in a note Monday.
“We estimate consensus earnings expectations for 2023 are 10% to 20% too high,” she wrote. “Based on our forecast, stocks are selling at a relatively risky price of 20 times earnings.”
“While some analysts cut estimates based on lower profit margins, few cut sales forecasts,” Shalett said, pointing to the chart above.
The bank’s global investment committee sees “such reluctance as an increasing risk,” she wrote, as “sales and, in turn, earnings will be impacted by the loss of volumes and power of fixing prices as the economy slows down”.
The S&P 500, which is a capitalization-weighted index of large-cap stocks in the United States, is currently trading around “17 times already expensive forward earnings,” Shalett said. Based on Morgan’s Stanley’s below-consensus earnings forecast of $195 per share for the index, “the implied forward multiple rises to 20.”
The S&P 500 SPX,
was down 0.4% in early afternoon Monday to around 3,948, according to FactSet data, when last checked. That was below its 200-day moving average of nearly 4,065, with the index down about 17% so far this year.
“While many equity investors are eager to end the bear market, we believe it is premature to do so,” Shalett said. “Investors may have given up on the inflation narrative, but they can’t avoid worries about slowing growth and the risk of recession.”
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Its note expressed concern over the “deteriorating PMI”, which refers to the Purchasing Managers’ Index data, and “weakening new orders”. Meanwhile, earnings expectations for 2023 are “unrealistic”, with the global consensus still predicting growth next year, she said.
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The outlook for stocks “isn’t bright,” according to Shalett.
But while stocks look “overvalued”, bond yields are “attractive”, she wrote. “History suggests that as the Fed’s hike cycles mature and yield curves reach their maximum inversion – which may have happened in the past week – investors should favor bonds over to shares.”
Shalett said investors should consider “reducing exposure to large-cap indices” by overweighting U.S. Treasuries, municipal bonds and investment-grade corporate bonds.
The yield of the 10-year Treasury note TMUBMUSD10Y,
was flat at 3.81% in early Monday afternoon, while two-year Treasury yields TMUBMUSD02Y,
rose 2 basis points to 4.52%, according to FactSet data, when last checked. This is considered an inversion of the yield curve, as long-term rates generally trade above short-term rates.
Historically, the reversal of 10-year and 2-year yields in the US Treasury market preceded a recession.
“Don’t confuse the beginning of the end of the bear market with the end itself,” Shalett warned. “In equities, active management and the equally-weighted S&P 500 are expected to outperform the benchmark S&P 500, which is capitalization-weighted.”
The Invesco S&P 500 RSP Equal Weight ETF,
is down about 11.5% so far this year, faring better than the S&P 500 based on early Monday afternoon trading.
See: ‘A real big sigh of relief’: Stock and bond ETFs jump on inflation report as investors consider equal-weighted strategies