The world’s top equity strategist says an ‘earnings recession’ is imminent for the markets – and it could be similar to what happened during the 2008 financial crisis

In bear markets, stocks generally do not fall in a straight line.

Over the past 50 years, even during the worst financial crises of modern times, there have been an average of 6.5 brief rallies per bear market.

No wonder this year was no different. But all along, Morgan Stanley’s chief investment officer and US equity strategist Mike Wilson have been warning investors not to fall for these “bear market traps.”

And even after falling more than 20% in the S&P 500 this year, Wilson, who in the last Institutional investor survey – believes the shares will fall even further. Investors were too focused on the Federal Reserve’s rate hikes and inflation, he says, when the real problem is declining economic growth and corporate earnings.

“The earnings recession on its own could be similar to what happened in 2008/2009,” Wilson wrote in a Monday research note. “Our advice: Don’t assume the market is pricing this kind of outcome until it actually happens.”

Wilson thinks the S&P 500 will fall to between 3,000 and 3,300 in the first quarter of 2023, from about 3,800 today. And by the end of next year, he expects the index to recover to just 3,900, or even 3,500 in a bear case.

But despite recent economic doomsday predictions from Wall Street for a recession that is “twice as long as normal” or even “another variant of a Great Depression,” Wilson said the economy is likely to weather rising interest rates and high inflation, or at least avoid a “balance sheet recession” and “systemic risks”.

For investors, on the other hand, the strategist offered a chilling warning: “[P]rice falls for stocks will be much worse than what most investors expect.”

A flashback to August 2008?

In his Monday note, Wilson said investors are making the same mistake they made in August 2008: They underestimate the risk that corporate earnings will fall.

“We’re bringing this up because we often hear from customers that everyone knows that next year’s earnings are too high and that’s why the market has priced in,” he wrote, citing optimistic earnings forecasts. “However, we remember hearing similar things in August 2008, when the spread between our revenue model and the street consensus was just as wide.”

For some backgrounds, the US economy was already in recession in mid-August 2008 and the S&P 500 was down 20% year over year to about 1,300. Many investors began to think that the worst of the bear market was over, but then the low came to an end as corporate earnings fell.

In March of the following year, the blue-chip index stood at just 683. Wilson made a chart in his note comparing some key stock market stats from August 2008 to today.

In it, he pointed to the fact that the S&P 500 is currently still richly valued by investors. In August 2008, it traded at about 13 times earnings, but today it’s up to 16.8 times.

The Federal Reserve had also cut interest rates by 3.25% in an effort to save the US economy from what would later become known as the Great Financial Crisis.

Today, it plans to raise rates further and keep them high to fight inflation. Wilson said “the Fed may be more bound this time” by high inflation, meaning it is less able to save stocks through rate cuts if a recession hits.

Year-on-year inflation, as measured by the consumer price index, was 5.3% in August 2008, compared to 7.1% now.

Wilson doesn’t believe stocks will fall as much as they did in 2008 because the housing market and banking system are in better shape, but he still expects the S&P 500 to fall to new lows as a result of this recession.

And even avoiding a recession may not be a good thing for investors.

“While some investors may take comfort in that as a signal that we can avoid an economic recession next year, aka a ‘soft landing’, we want to caution against that outcome for equity investors, because in our view it simply means there is no relief. . coming from the Fed even as earnings forecasts are cut,” Wilson wrote.

Throughout 2022, many equity investors hoped that inflation would fall, allowing the Fed to pause rate hikes or even cut rates. But Wilson argues that profits will suffer if inflation eases because U.S. companies were able to increase profits by raising prices and passing on extra costs to consumers.

“Tariffs and inflation may have peaked, but we see that as a warning sign for profitability, a reality that we believe is still undervalued but can no longer be ignored,” he wrote Monday, adding that the “earnings outlook is deteriorated” in recent months.

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