Morgan Stanley’s Mike Wilson is one of Wall Street’s most vocal bears. But even he thinks this bear-market rally has more room to run.
After the Dow Jones Industrial Average DJIA, -0.20%, S&P 500 SPX, -0.30% and Nasdaq Composite COMP, -0.72% cemented their strongest weekly gains since at least May on Friday, Wilson — who is the chief U.S. equity strategist and chief investment officer at Morgan Stanley — told clients that there could be another 5% to 7% upside left to this latest bear-market bounce before U.S. stocks resume their downward trajectory.
Wilson explained in a research note sent to clients on Monday that a retracement of 38% to 50% of the stock market’s selloff so far this year “would not be unnatural or out of line with prior bear market rallies.”
However, while growth fears have helped trigger a selloff in commodities and a moderation in inflation expectations, the fact that the U.S. economy is already slowing — and could be headed for a recession, although that’s not Morgan Stanley’s base case — means any rally will likely be short-lived, and that U.S. stocks would likely ultimately turn lower.
“The bear market is likely not over although it may feel like it over the next few weeks as markets take the lower rates as a sign the Fed can orchestrate a soft landing and prevent a meaningful revision to earnings forecasts,” Wilson wrote in a research note sent to Morgan Stanley’s clients.
Wilson, who has been bearish on stocks for roughly two years, correctly called the selloff in stocks this year.
U.S. stocks rallied over the past week as investors bet that slowing growth and falling commodity prices might inspire the Fed to raise interest rates less aggressively. Fed funds futures, a derivative product used by investors to place bets on the path of benchmark interest rates, have started to price in a higher possibility that the Fed will be forced to start cutting interest rates again as soon as next summer.
They are also pricing in a lower peak in the fed-funds rate: now, investors see the U.S. benchmark interest rate topping out at around 3.5% at the end of 2022, compared with 3.75% just a couple of weeks ago, according to the CME Group’s FedWatch tool.
Wilson also pointed out the drop in Treasury yields, which sent the 10-year Treasury yield TMUBMUSD10Y, 3.210% to a low of 3.07% on Friday before rebounding on Monday.
Wilson expects the S&P 500 to bottom around 3,400 if the Federal Reserve succeeds in achieving its “soft landing” for the U.S. economy — something that Fed Chairman Jerome Powell said last week would be “very challenging” to achieve.
If the U.S. economy slides into recession, Wilson expects the S&P 500 could bottom around 3,000. At any rate, Wilson believes U.S. equities are still richly valued as the equity risk premium — a measure of the compensation investors receive for the additional risk of holding stocks instead of bonds — remains about 300 basis points higher than the 10-year Treasury yield, which is considered the “risk free rate”. This generous premium makes little sense to Wilson, who believes forward earnings for the S&P 500 will soon be revised sharply lower to reflect the growing risk of recession.
Read: How to tell when the bear market is almost over
Wilson isn’t the only Wall Street strategist expecting a near-term bounce. JP Morgan’s Marko Kolanovic expects the bear-market rally in stocks could continue this week as quarter- and month-end rebalancing help to lift equities.
Meanwhile, Barry Bannister, chief equity strategist at Stifel, said last week that “cyclical growth” stocks could help lead a relief rally that brings the S&P 500 back to 4,150. Wilson expects the index will top out around 4,200 before it heads lower.
U.S. stocks swung between gains and losses early Monday, with the S&P 500 up 0.2% at 3,923 in recent trade, while the Dow Jones Industrial Average rose about 80 points to 31,580. The Nasdaq Composite was slightly lower at 11,606.
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