Morgan Stanley's top strategist and chief investment officer Mike Wilson made a name for himself in late 2021 when, with the market riding high and seemingly no end in sight, he predicted a meltdown in 2022. That prediction came true when the benchmark S&P 500 fell roughly 20% last year.
Wilson was fairly pessimistic heading into this year as well, although so far the market is having an excellent year. But Wilson is still bearish and thinks stocks are vulnerable, especially as we head into the second-quarter earnings season. Here's why.
Corporate earnings need to step up
Second-quarter earnings will kick off Friday with the big banks, and consensus estimates are by and large forecasting a sharp earnings reduction across the board in the second quarter. On the whole, analysts expect earnings to fall 9% year over year in Q2.
Now, this isn't the first time investors have expected corporate earnings to cool off. But stocks have managed to keep rising through the first half of the year by beating estimates and outperforming expectations. This, along with hopes the Federal Reserve will soon end its aggressive interest rate-hiking campaign, has driven the S&P 500 up more than 15% this year.
"With second-quarter earnings beginning this week, 'better than feared' likely isn't going to cut it anymore," Wilson wrote in a recent research note, adding that valuations are at risk with higher rates and liquidity starting to run thin. "[T]he key for stocks will come via company guidance for the out quarter rather than the results themselves."
Wilson, as well as other strategists, think earnings could be due for another downward revision from analysts, which may exacerbate an earnings recession.
The broader market also looks very fully valued with the Shiller CAPE Ratio at levels that have usually resulted in a steep decline. The Shiller CAPE Ratio looks at the price of the S&P 500 divided by average inflation-adjusted earnings from the past decade.
Data by YCharts.
While the Shiller CAPE Ratio is not nearly as high as it was in late 2021, it's still at levels that are high for the broad market historically, and it's also been very difficult for the broad market to hold a Shiller CAPE Ratio of more than 30.
Risks remain
I certainly do not think investors should take their eye off the ball, because many stocks have seen their valuations run up considerably this year, namely in the tech and artificial intelligence space.
We also still do not entirely know when the Fed will stop raising rates, whether there will be a recession, and what will happen as liquidity and excess savings from stimulus efforts finally run down.
A big mistake that investors made in 2021 was simply ignoring sky-high valuations and thinking that everything should trade at a high multiple to sales, so investors do need to make sure they can justify current valuations.
That said, the market has been carried by a limited number of stocks this year, and there are many still trading at cheap valuations that haven't fully recovered. There are still opportunities out there, so it's more a matter of not getting too excited and making sure you can justify the price of a stock, as well as making sure it can navigate a range of different economic environments.
