EDITOR NOTE: Look at the S&P 500, the Nasdaq 100, and the Dow--all three will show you a “double top.” The second top is stopping short of the high established last month. This signals market weakness, indicating a potential trend reversal. The article below is a bit technical for many mainstream readers but that’s essentially what it’s saying. Morgan Stanley is predicting a 10% correction. That’s a fair forecast. It’s also near-term. Myopic. Looking at the longer-term fundamentals, economic prospects look much worse for most Americans, regardless of what the Fed-driven market is doing.
Back on September 2, when stocks hit an all time high, we asked if it "could be this simple" when showing the long-term resistance of the S&P:
Well, at least so far, the answer appears to be yes and is also the reason why in his weekly focus note, Morgan Stanley's chief equity strategist Michael Wilson writes that last week's failure to break through technical resistance for second time "suggests the correction isn't over."
To that point, last month and shortly after our initial observation, Wilson laid out his view that long-term resistance in the S&P500 around the 3550 level would be very difficult to surpass prior to the outcome of the US election and passage of CARES 2. As he explains "this view was based on very strong long-term technical resistance going back to the late 1980s."
Then, just days later, the index quickly retreated for its first 10% correction in this new bull market, and while last Monday the index once again staged a valiant effort to break through, it was thwarted once again. Of concern to Wilson is that this second attempt occurred on less momentum, "suggesting the correction that began in September is likely not complete."
Furthermore, the Morgan Stanley strategist also highlights the lack of a fiscal stimulus deal, election outcome/timing of final results, and second wave of the virus "as the primary headwinds to higher prices in the near term."
So with both fundamentals drivers and technicals limiting stock upside limited, with so many uncertainties over the next month Wilson says that "another 10% correction from Monday's highs is the most likely outcome in the near term before this bull market can resume, at least at the index level."
Next, to quantify the potential downside, Wilson says that he continues to view the 200-day moving average for formidable support from a technical standpoint, which today is at 3123.
Then, from a valuation perspective, Wilson refers to one of his preferred market indicators, the Equity Risk Premium, which he says "looks too low" given the near-term uncertainties and upside risk to long-term rates we see. As such, he would be more comfortable with a buffer of 50 bps to add risk here. Such an adjustment implies an ERP of ~425bps rather than the 375bps indicated by current level of realized vol and is shown in the next chart.
It's also how he gets the 10% downside estimate: at 380 bps and with a 10-year Treasury yield at 0.75%, the current S&P 500 P/E multiple is ~22x. If one add the 50bps buffer noted above to the implied ERP from Exhibit 3 while holding the 10-year yield constant, we get a 2 multiple drop in the P/E to 20x, which implies 10% downside. Coincidentally, this also lines up with the 200-day moving average noted above.
Bottom line, Morgan Stanley urges investors to remain "disciplined" on new money entry points, favoring the low end of our 3100-3550 range we established back in August.
Finally, to avoid any bearish labels, Wilson as usual concludes on a bullish note, writing that the recovery and new bull market "remain on track to resume next year. More importantly, we think the average stock will outperform the major average (SPX), which is now highly concentrated to the top 20 largest stocks." He believes that the best way to express this view is by owning an equal weighted S&P 500 relative to the market cap weighed S&P or by skewing one's portfolio to smaller capitalization stocks that can deliver better operating leverage and earnings growth next year.
Originally posted on ZeroHedge