Morgan Stanley's US equity chief explains why the recent meltdown signaled the 'final stage' of the bull market
- Morgan Stanley chief US equity strategist Mike Wilson says that stocks have entered the final stage of their almost nine-year bull market run.
- In a wide-ranging discussion, Wilson outlined his views on the current market cycle, broke down his 2018 forecast, opined on the much-maligned short-volatility trade, and predicted how stock-pickers will fare in the coming months.
The stock market's recent selloff was enough to throw any expert off-balance. While many pundits had been calling for some sort of reckoning for months, the sheer speed and severity of the downward move was more aggressive than many envisioned.
Mike Wilson, the chief US equity strategist at Morgan Stanley, aligns himself with that camp. Sure, he saw the overbought conditions and stretched valuations that contributed to the meltdown from a mile away, but he wasn't expecting a 10% correction to transpire in just a week's time.Now that he's had adequate time to digest the madness, Wilson has reoriented his view on the stock market going forward. In his mind, the selloff was a turning point for stocks, and marked the nine-year bull market's entry into its final stage.
But that doesn't mean he thinks all the money has been made in stocks. Wilson says there are still ample returns and opportunities to be seized - if investors know where to look.
In an interview with Business Insider, Wilson outlined his views on the current market cycle, broke down his mildly bullish 2018 forecast, opined on the much-maligned short-volatility trade, and predicted how stock-pickers will fare in the coming months.
This interview has been edited for clarity and length.
Joe Ciolli: What stage of the bull market would you say we're in now, following the stock correction?
Mike Wilson: We're very late-cycle in the economic expansion, and I measure that primarily through the labor market. We're at full employment or just below it, and to me it's pretty clear that there's not much slack left in the economy - and that's usually the final stage of a market cycle. You see inflation start to pick up. The Fed is going forward with raising rates even though the yield curve might be flattening. Their mandate has been met, so they keep pushing forward. It's just a matter of timing.Could this expansion extend into 2020? It could, but I don't think it will. Keep in mind that there doesn't have to be a full-blown recession to have a meaningful decline in earnings. A big deceleration in economic growth is enough to cause a lot of problems for earnings.
Ciolli: Now that you've had a few days to reflect on it, what's your takeaway from the big stock market correction we saw?
Wilson: During January, I was a little surprised at how persistent the rally was, and I was kind of racking my brain as to why we didn't get any pause. We reached some of the most overbought conditions we've ever seen.
But at the same time, I get it. Earnings revisions were going up, and stocks follow that. But typically, when you actually get the earnings increase, multiples come down, but we didn't see that. And then of course it all happened at once.
When the selling started, I thought we would go down 10% - just not in a week. I really felt like that was going to be the beginning of this multiple contraction that I've been looking for, and we were going to reset the bar. I thought it would take several weeks to get down to 2,540, but of course it happened in one day. That was obviously expedited by these volatility strategies blowing up, which wasn't a surprise.
We reached some of the most overbought conditions we've ever seen
I felt like we did a lot of work in four days. We got to an attractive valuation level pretty quickly, and we retested the initial low. We saw some defensive rotation. I felt like I felt like the market had adjusted itself rather quickly. That got me thinking that we could step in here again.
I feel like we're going to chop around now, because the volatility market has to heal itself. I do feel like the VIX is going to remain at a higher level than what we've been living with. We're not going to stay at a 29 VIX, but I don't think we're going back to 9 either. It usually takes time to work our way back down to the mid-teens.
Ciolli: Now that we have your main takeaways, what would you say triggered the market event in the first place?Wilson: The initial shock was a result of rates hitting a level that started to affect valuations. When interest rates went up so quickly, that put pressure on price-earnings multiples. And then there was also the flattening of earnings revisions.
On December 18, forward 12-month earnings estimates for the S&P 500 were $145. Today they're $159, but they're starting to flatten out. The reality is that tax cuts have been priced in - they're not going to move earnings up more than the 9.5% we've already seen.
That, combined with the volatility strategy blow-up - which caused risk reduction in other portfolios - stirred up more volatility. And that, in turn, caused more forced selling.
Now, volatility is going to come down, and people are going to feel comfortable again. They're going to bid stocks back up. But they're missing the message that the market is starting to get concerned about earnings growth continuing at such a fast pace. That should be a concern, and it's something we're going to have to worry about in the second half of this year.
Ciolli: Your base case year-end S&P 500 price target is 2,750. Can you walk through the path you think we'll take to get there?
Wilson: Coming into 2018, we felt like the earnings increase was going to get baked in early, and then throughout the year multiples would come down gradually as investors realized that the quality of the earnings increase is lower. We also expected to have a big deceleration in terms of the growth rate.
And then of course interest rates are the final piece here. As they continue to go up, and people get more worried about the Fed and financial conditions tightening, that creates higher volatility. All that is happening now - it's just happening at a faster speed. I think we've cleaned out a lot of speculation in the last two or three weeks.
We've cleaned out a lot of speculation in the last two or three weeks
As we go through the year, people are going to start feeling better again, because the earnings story is good, and there's nothing negative to say about the economy. My guess is that, after volatility calms down, people will get bullish again and drive asset prices and stocks up one more time.
We'll probably make some new highs this summer - maybe we'll get as high as 3,000 - but then ultimately, in the second half of this year, we're going to see multiples come down again. Because we'll be staring down 2019, which will be a tougher year, marked by slower growth. Financial conditions will be much tighter, and the yield curve will be flat, and volatility will be higher. It will all lower multiples.Ciolli: Are you relieved that those short-volatility positions blew up?
Wilson: We cleansed a risk that was out there for the marketplace. And it wasn't just those products. It also included risk-parity strategies and volatility-targeting funds. Obviously if volatility picks up in the broader market, they have to reduce their risk.
I'm somewhat encouraged actually that as volatility spiked so much, the selloff was relatively contained to around 10%, and only lasted for 4-5 days. I think the markets handled it extremely well. That's encouraging. It tells me that the integrity of the market is actually better than some had been fearing, given fears over passive investment and crowding.
If we ever do have a real fundamental selloff or recession, people are worried that there's going to be unlimited selling from these strategies, but I think that's wrong. The market handled this risk very efficiently.
Ciolli: You've repeatedly stressed in your research that conditions are ideal for stock-pickers. Do you still believe this?
Wilson: It's been a good stock-picking market for the last 18 months, at least by our data. Stocks have been trading on their own merit, and I think that will continue once the dust settles here. If we're really in a late-cycle environment, which I think we are, it usually gets narrower as fewer stocks beat the overall market. Which means you have to get better at picking the winners.
Just because there are more opportunities doesn't mean it gets easier
While stock-picking was still rewarded over the last year, it was easier than it will be going forward, when we have more losers than winners. Just because there are more opportunities doesn't mean it gets easier
In last 18 months, picking sectors was pretty easy, and you were rewarded for that. For the next six months, the sector factors won't be as important as the single-stock ones.
Ciolli: Speaking of sectors - are there any you favor? Dislike?Wilson: We're seeing more dispersion between winners and losers in the internet space, and the same has been true for semiconductors. That's a departure from last year, when they were all going up. I think there's going to be more dispersion between sectors, which is very typical at this stage of the economic cycle.
Semiconductors is a sector where more stocks are going down than up, breadth is deteriorating, the fundamental picture is getting worse at the margin - there are a lot of signs showing excess there. And that makes sense because semis are an early-cycle group, and that's where excesses show up first. Restaurants, homebuilders and transportation stocks are all very early-cycle, and they tend to turn down before the rest of the market does.
On the positive side, I like some of the late-cycle stuff like materials and energy. Energy may be able to make another run here, depending on commodity prices. Beyond that, I think it'll be more idiosyncratic. Even in financials, I think you'll see some differentiation between the winners and losers. Healthcare is always that way, as is consumer discretionary.
Ciolli: What scares you the most about the market right now?
Wilson: The last couple of weeks took care of a lot of concerns. Before the selloff, I was worried about the market being overbought, and sentiment being so extreme - but those have been largely taken care of.
The stock market is fairly priced now, if not cheap again. But we could still be surprised if inflation data comes in crazy high, and people freak out and rates spike. That would be very destabilizing in the equity market in a way that you just can't prepare for. It's the pricing mechanism for everything. That's definitely a risk, although I'm not necessarily in that camp, but I could be wrong.
The stock market is fairly priced now, if not cheap againPeople also aren't thinking about the end of the cycle in the right way. They're thinking about it from a demand standpoint, when they should be looking at it from a supply shock standpoint. The economy can only run so hot, and we're pushing that speed limit now.
Ciolli: What's the best advice you can offer to a young investor?
Wilson: Unfortunately, the millennial generation grew up in a secular bear market. They came of age at a time when investing in the stock market was a bad deal.
A young investor needs to understand history and past market cycles. Investing in equities, generally speaking, is going to be a very good deal over the next 6-7 years.
A lot of younger people are interested in things like cryptocurrencies, or alternative investments, because they've kind of turned their backs on stocks, but that's a mistake. Stocks need to be a big part of someone's retirement or savings. It's still one of the best ways to compound savings over a long period of time.
And those who do own stocks should own international exposure, because those markets are cheaper, and they're several years behind the US. And it shouldn't all be emerging markets. You need to own some Japan and Europe, the whole nine yards.