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Last week’s price action showed signs of panic buying by investors who are afraid they’ll miss the next bull market. We believe this will prove to be a head fake rally like last summer’s, for many reasons.

First, valuations are not attractive, and it’s not just the top 10-20 stocks that are expensive. The S&P 500 median stock forward P/E is 18.3x (in the top 15% of historical levels back to the mid-1990s), the S&P 500 ex-tech median P/E is 18.0x (also within the top 15% of historical levels) and the equity risk premium is only 200bp.

Second, a very healthy re-acceleration is baked into 2H consensus earnings estimates (mid-to-high single-digit growth for both the overall index and the index ex-tech). This flies directly in the face of our forecasts, which continue to point materially lower. We remain highly confident in our model given how accurate it has been over time and recently. We first started talking about the coming earnings recession a year ago and received very strong pushback, just like today. However, our model proved quite prescient based on the results and is now projecting a much more dire outcome than consensus. Given its historical and more recent track record, we think consensus estimates are off by as much as 20% for this year.

Other reasons we are wary of the current rally:

• The equity market is now pricing in Fed cuts before year-end without any material implications for growth. Yet, Morgan Stanley economists believe the Fed will only cut rates if we definitively enter a recession, or if stresses in the banking system increase and/or credit markets deteriorate significantly. What’s more, the Fed cuts currently in the price implicitly assume that inflation will fall to at least 3%. That is possible, but not without significant growth implications.

• There’s also a presumption that the banking situation will not worsen and become systemic. While we don’t think this is 2008-09, we do think it will accelerate the credit crunch that was already likely to begin by year-end, based on loan officer surveys from January.

• The war in Ukraine and the situation in Taiwan are not expected to escalate.

• While the consumer has been quite resilient in the face of a number of headwinds, some signs are emerging that this strength may finally be fading. Discretionary spending intentions have slowed according to our recent surveys, even for high-end consumers.

• Finally, while a debt ceiling resolution removes a near-term market risk, a material dislocation was never priced in and the bigger risk for markets now is that raising the debt ceiling could decrease market liquidity based on the sizeable Treasury issuance we expect over the six months after it passes.

Bottom line, while many individual stocks and sectors have traded poorly this year, the major indices are priced for simultaneous good outcomes on multiple fronts where we think risks are elevated and even increasing in several instances. We suspect passing the debt ceiling may ironically be the catalyst that ends this bear market rally as it leads to a contraction in liquidity. Thus, it’s the mirror image of the bank failures in March, which turned out to be the bad news that led to increased liquidity from the Fed/FDIC and good news for markets. Beware of a false breakout as markets top on good news.

Morgan Stanley

  

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