Morgan Stanley Sees S&P 500 at Risk of 10% Drop in Third Quarter

(Bloomberg) -- Morgan Stanley’s Mike Wilson, one of Wall Street’s most skeptical equity strategists, just issued another warning as the market hovers near a record high.

The S&P 500 Index is likely to fall into a 10% correction in the third quarter if economic data continues to deteriorate, according to the bank’s chief U.S. equity strategist. Although the potential for a cease-fire in the U.S.-China trade war at the Group of 20 summit could add to the lift markets recently got from a dovish Federal Reserve, neither is enough to stop an economic slowdown, Wilson said.

While optimism over trade could propel the S&P 500 above 3,000, the firm’s bull-case target for the year, the downside risk is much bigger, Wilson said. He expects the index to end the year at 2,750, a 7% decline from an all-time high of 2,954 reached last week.

“We remain convinced that fundamentals are worsening more than most acknowledge, and don’t see the Fed or G-20 outcome changing that trajectory,” Wilson wrote in a note to clients. “We struggle to see a case for much more upside for the market and think that the market, much like the Fed, should start to become more data dependent.”

Wilson has shown a tendency to lean bearish during the last two years as the bull market has become by some measures the longest in history. In 2018, his year-end target was the closest to where the S&P 500 actually ended after the index plunged 14% in the fourth quarter. This year he has been sticking to his cautious view, despite a rally that forced him to issue a mea culpa in April.

U.S. stocks have brushed aside weaker-than-expected economic data as Fed officials opened the door for rate cuts. The S&P 500 has jumped more than 7% this month, surpassing the average year-end target of 2,912 from strategists tracked by Bloomberg.

Citigroup’s Economic Surprise Index, which measures the difference between actual releases and economist expectations, has been below zero since February amid a string of weak reports on employment and factory orders. Morgan Stanley’s business conditions index just posted a record monthly drop in data going back to 2002, with readings now near the lowest level since the 2008 financial crisis.

“If the Fed is cutting rates because it’s truly the end of the cycle, rather than the Fed simply taking out insurance against that outcome, it has much different implications for equity markets,” Wilson said. “The evidence is building that it’s more the former than the latter.”

One data point Wilson’s team is paying particular attention to is the Cass Freight Index, viewed as a broad measure of economic activity. The gauge just fell 6.5% from a year earlier, accelerating a slowdown that started even before the latest episode of U.S.-China trade tensions. Further deterioration could send “a real signal” about the recession risk.

“We continue to recommend investors take exposure down until there is a clearer trend in place,” Wilson wrote. “Even those who disagree and see the case for upside should consider expressing that view via optionality or hedge to limit downside risk.”

To contact the reporter on this story: Lu Wang in New York at lwang8@bloomberg.net

To contact the editors responsible for this story: Brad Olesen at bolesen3@bloomberg.net, Richard Richtmyer, Brendan Walsh

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