Expect More Volatility in the US Equity Market – Morgan Stanley

So far, 2017 returns have been good for US equity investors. 2018 won’t repeat that, according to Morgan Stanley’s strategists in a report published today.

Per MS’s Michael J Wilson, Adam Virgadamo, Adnrew B. Pauker and Michelle M. Weaver:

« We think the breadth and stability of equity markets reflect the synchronous economic recovery and very low dispersion in earnings estimates, not complacency by investors. However, such calm is likely to wane in 2018 as the recovery becomes less synchronous and decelerates at some point as the data begin to roll over from unsustainably high surprise ratios. We expect earnings growth will also peak in 1H 2018 which inevitably will bring some heartburn for investors. »

Euphoria is not there yet, they add, but it’s coming, if you look at sentiment indicators.

« The absence of strong and persistent equity flows from retail investors may be the final missing ingredient to conclude this cyclical bull market », says the bank.

Despite the risk of a significant drawdown, MS is unsurprisingly optimistic when it comes to devise market predictions: S&P 500 is seen at 2,750 points by the end of 2018, but could be reached as early as 1H 2018, « at which point the risk reward would become very unattractive ».

The bank has a bear case where S&P would fall back to 2,300 and a bull case at 3,000 points (compared with 2,599 points as of Nov 21).

Views on fundamentals 

According to consensus, S&P 500 EPS is seen at $145.9, up 10.9% from 2017 estimate of $131.6. In 2019, the market currently expects EPS to grow another 9.9% to $160.5.

« …based on consensus forecasts, 2018 looks a bit aggressive at $146 implying yet another year of double digit growth in the 9th year of this economic expansion. Of course, with tax cuts looking more likely, that 10% growth is much more achievable than without them. Our base case assumption on tax relief is that the plan is enacted by 1Q retroactive to the beginning of the year and should boost S&P 500 EPS by approximately 5%. That means we only need 5-6% organic EPS growth to hit the current forecasts which seems very doable even if growth slows in the second half of 2018 as suggested by our top down S&P EPS growth model. »

Which sector plays ?

According to Morgan Stanley:

« First of all, we remain overweight classic late cycle sectors: Technology, Energy, and Industrials. All three have been working well lately with capital spending returning and oil prices moving higher, both of which are common late cycle phenomena we expected to see and cited as reasons to be overweight these sectors. »

That’s for the overweight. Now the sectors to avoird/underweight:

« We have been underweight the defensive bond proxies – Staples, REITs and Telecom – during 2017 and we remain so. This has worked in an accelerating global economy where output gaps are shrinking, inventories are building and signs of reflation are evident. At some point in 2018, we expect to upgrade one or more of these sectors as the late cycle matures and gets closer to the inevitable cycle top. »

Higher Volatility

Of course, volatility will be the name of the game next year. And it might be a broad phenomena, in terms of asset classes: both equity and interest rates will be affected, pending the continued tightening of monetary policy.

And actually betting on a rise in volatility might be a no brainer right now (or isn’t it a bit early if you expect euphoria to reach its peak over the next 6-7 months ?).

Per MS’s report:

« after a very painful slide in volatility for many traders looking for a rise the past several years, we have finally reached a point where betting on higher volatility will pay off. »

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