Morgan Stanley says beware bear market rallies, S&P 500 headed to 3,400

Published Mon, May 16 20223:06 PM EDTUpdated Mon, May 16 20226:35 PM EDT

Stocks are trying to dig their way out of last week's steep losses, but Morgan Stanley is warning that these relief rallies are fleeting and more declines will follow. "With valuations now more attractive, equity markets so oversold and rates potentially stabilizing below 3%, stocks appear to have begun another material bear market rally," Michael Wilson, chief U.S. equity strategist at the firm, said in a note to investors Sunday. "After that, we remain confident that lower prices are still ahead," he added. "In S & P 500 terms we think that level is close to 3,400, which is where both valuation and technical support lie." The S & P 500 closed down 0.39% on Monday following a bout of fitful trading. The index ended the previous session at 4,023.89, and it's now down more than 15% for the year. The primary concern for stocks has become growth rather than inflation, the Federal Reserve and interest rates. Stocks sold off in April, which is typically a strong month for equities. In the past week, the S & P 500's price-to-earnings ratio contracted due to the sharp rise in equity risk premiums (ERP), while Treasury yields fell, Wilson found. Equity risk premium is the return generated by an asset over the risk-free rate of return. Initially, that situation is what Morgan Stanley strategists were waiting for to call a bottom on this bear market. However, even though that scenario has now played out, stocks still have further to fall before a meaningful rebound, according to Wilson. That's because earnings risk lies ahead, he said, noting that while second-quarter estimates for the S & P 500 came down, full-year estimates were unchanged. That raises the bar for the second half of 2022, at which time the economy will be feeling the effects of higher rates and other headwinds, the strategist found. "The bottom line is that this bear market will not be over until either valuations fall to levels (14-15x) that discount the kind of earnings cuts we envision, or earnings estimates get cut," Wilson wrote. "The question is will the equity market go ahead and discount the earnings cuts we think are coming or will it require companies to formally cut guidance?" he said. "Given the pervasive bearishness now and extreme oversold conditions, we could see it play out either way."