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In One Chart: Beware ‘unrealistic complacency’ in stock market, Morgan Stanley warns

The U.S. stock market’s tie to company earnings expectations may be a risk as investors appear optimistic in the face of inflationary pressures, according to Morgan Stanley.

The S&P 500 index’s rise for most of this year has been tied to an “ever-improving outlook” for company earnings, with a trend of positive revisions to earnings forecasts and stronger results swamping the “modest” compression in valuations due to higher inflation, Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management, wrote in a note this week. Forward 12-month estimates have continued to grind higher even as “earnings revision breadth has finally rolled over.”

A chart in the Morgan Stanley report raises concern over the stock market’s “tether” to earnings expectations. “Since January, full-year forward estimates have risen by 20% to 30%, depending on how you measure them, in large part as analysts extrapolated extraordinary second quarter operating leverage,” Shalett wrote.

MORGAN STANLEY REPORT DATED SEPT. 27, 2021

Investors will be watching for a barrage of third-quarter reports in October, with particular attention paid to guidance from company management on the outlook for their businesses. With the stock market trading not far from record highs this year, Shalett expressed caution.

“Our conviction in a correction catalyzed by higher-than-expected inflation and worse-than-forecast earnings has risen,” she said. “Producer prices are outpacing consumer prices at levels associated with declining S&P 500 operating margins on a forward 12-month basis.”

Meanwhile, profits per share are estimated at about $219 for 2022, up from this year’s forecast for $203 a share, according to the note, dated Sept. 27. “That’s despite the fact that, on second quarter earnings calls, 224 of the companies in the S&P 500 already cited inflation as a risk.”

DataTrek Research has been pointing to third-quarter earnings as an area of potential concern for the U.S. stock market, as Wall Street analysts have trimmed estimates for company results. 

“We no longer have the tailwind of analysts increasing S&P 500 earnings estimates every week,” DataTrek co-founder Nicholas Colas wrote in a note Wednesday. “As we’ve noted in every Sunday evening report for the last 3 weeks, they are in fact cutting numbers for Q3.”

That will probably continue until companies begin reporting results next month, according to Colas.

Read: Brace for ‘choppy’ market after Wall Street analysts trim S&P 500 earnings estimates for third quarter

U.S. stocks fell sharply Tuesday, with the S&P 500 sliding 2% in its biggest drop since May. But on Wednesday morning investors were wading back into the market for buying opportunities, with the index
SPX,
+0.16%

up about 0.6% in afternoon trading.

The “buy the dip mentality” this year has been supported by “robust” earnings estimates, with investors demonstrating confidence amid mentions of “stagflation” as a potential risk for markets, according to Shalett. Second-quarter earnings defied expectations, “with beats averaging 85%,” bolstering investor confidence, she said.

Meanwhile forecasts for the growth rate of gross domestic product in the third quarter have been revised lower, she said, and historically high inflation remains well above the Federal Reserve’s target of an average 2%. 

“Although September is historically among the weakest months, we view market action as demonstrating extraordinary resilience given meaningful deterioration in fundamental data,” Shalett wrote. She cautioned investors that looking through third-quarter macroeconomic data, however tempting, may reflect “unrealistic complacency.”

“From our experience, it is rare for the macro to be this divorced from the micro,” she said. “Ultimately even the mightiest secular growth stocks take profit cues from GDP and inflation.”

See: Stocks may fall 15% by year-end, warns Morgan Stanley. Here are some portfolio moves investors might consider.

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