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In One Chart: Favor bonds as stocks look expensive amid Wall Street’s ‘timid approach’ to earnings revisions, says Morgan Stanley

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Wall Street’s “timid approach to earnings revisions sets up risks” for the U.S. stock market, which already is expensive, according to the chief investment officer of Morgan Stanley’s wealth-management business.

The consensus earnings forecast for the S&P 500 in 2023 has fallen to $230 a share, “down only $10” despite aggressive monetary tightening by the Federal Reserve as it tries to tame high inflation, “increasingly negative” guidance from managers of companies and signs of economic weakening, said Lisa Shalett, CIO of Morgan Stanley Wealth Management, in a note Monday.

“We estimate 2023 consensus earnings expectations are 10% to 20% too high,” she wrote. “Based on our forecast, stocks sell at a relatively risky 20 times earnings.”

MORGAN STANLEY WEALTH MANAGEMENT NOTE DATED NOV. 21, 2022

“While some analysts have cut estimates premised on lower profit margins, few have reduced sales forecasts,” said Shalett, pointing to the chart above.

The bank’s global investment committee views “such reticence as a growing risk,” she wrote, as “sales and, in turn, profits will be hit by loss of volumes and pricing power as the economy slows.”

The S&P 500, which is a capitalization-weighted index of large-cap stocks in the U.S., is currently trading around “an already expensive 17 times forward earnings,” Shalett said. Based on Morgan’s Stanley’s below-consensus earnings forecast of $195 per share for the index, “the implied forward multiple rises to 20.”

The S&P 500
SPX,
-0.22%

was down 0.4% early afternoon Monday at about 3,948, according to FactSet data, at last check. That was below its 200-day moving average of almost 4,065, with the index down around 17% so far this year. 

“While many equity investors are impatient to call an end to the bear market, we think it is premature to do so,” said Shalett. “Investors may have moved on from the inflation narrative, but they cannot avoid the concerns about a slowdown in growth and the risk of recession.”

Read: U.S. inflation shows signs of easing, perhaps giving Fed ammo to go slower

Her note expressed concern over “deteriorating PMIs,” which refers to data from the purchasing managers index, and “weakening new orders.” Meanwhile, 2023 earnings expectations are “unrealistic,” with the aggregate consensus still forecasting growth next year, she said.

Read: Barclays says cash may be ‘real winner’ in 2023 while recommending bonds over stocks

The outlook for stocks “is not bright,” according to Shalett.

But while equities appear “overpriced,” bond yields are “attractive,” she wrote. “History suggests that as Fed hiking cycles mature and yield curves reach maximum inversion — which may have occurred last week — investors should favor bonds over stocks.”

Shalett said investors should consider “reducing large-cap index exposure” by overweighting U.S. Treasurys, municipal bonds and investment-grade corporate bonds. 

The yield on the 10-year Treasury note
TMUBMUSD10Y,
3.827%

was flat at 3.81% in early afternoon trading Monday, while two-year Treasury yields
TMUBMUSD02Y,
4.535%

were up 2 basis points at 4.52%, FactSet data show, at last check. That’s viewed as an inversion of the yield curve as long-term rates typically trade above shorter-term ones.

Historically, the inversion of 10-year and 2-year yields in the U.S. Treasury market has preceded a recession.

“Don’t conflate the beginning of the end of the bear market with the end itself,” Shalett cautioned. “In equities, active management and the equal-weighted S&P 500 should trump the S&P 500 benchmark, which is cap-weighted.”  

The Invesco S&P 500 Equal Weight ETF
RSP,
-0.00%

is down around 11.5% so far this year, faring better than the S&P 500 based on early afternoon trading Monday.

See: ‘Real big sigh of relief’: Stock, bond ETFs jump on inflation report while investors eye equal-weighted strategies

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