With the second quarter coming to an end for the U.S. economy, there has been a noticeable decrease in interest rates, as the ten-year treasury yield fell to 2.833% on Tuesday.
Slowing Growth: The S&P 500 equity risk premium has risen to 340bp, while the fair value level is estimated to be 370bp, a Morgan Stanley analyst reported on Tuesday. The analyst also mentioned that these conditions are appropriate for more lows to come, and until earnings estimates are reduced, the bear market will not be over.
Due to the Ukraine war and the Chinese zero covid policy, the economic slowdown was exacerbated, leaving investors to determine how much earnings estimates should be cut, as stated by Michael Wilson.
Therefore, investors should seek equities with earnings stability, while higher quality equities will seek to reduce earnings expectations accordingly, Wilson added.
Interest Rates: As interest rates have continued to fall, there are two interpretations for how this will impact market direction. First, Wilson reported that the lowering of interest rates could cause a padding for equity valuations, signaling that the Fed will ease off its strict policy if inflation decreases in the second half of 2022.
Secondly, the Morgan Stanley analyst mentioned that stocks could continue to chase new lows as interest rates decline which would reflect a higher equity risk premium, adding that the fall in rates should be a concern in slowing growth.
Where Is There Earnings Risk: According to the analyst, the focus heading into this earning season is on forward earnings expectations, earnings revisions breadth, and which industries look more or less at risk of downgrades from a top-down industry standpoint.
The S&P and Nasdaq forward earnings estimates are both 20%+ above the post global financial crisis, as displayed in the Morgan Stanley report.
Additionally, earnings revisions breadth, which often leads forward dollar earnings per share, has further accelerated into negative territory signaling forward earnings are going to decelerate, Wilson said.
Although prices have trended lower, earnings estimates are still elevated, making it misleading to use multiples for a relative valuation, the Morgan Stanley analyst added.
Earnings Stability: While earnings estimates remain high for the second quarter, investors will be watching for earnings stability. According to Wilson, companies with earnings stability tend to have lower estimate dispersion, lower return on equity volatility, and lower sales growth volatility.
During the 2008 recession, the National Income and Products Accounts profits fell for four consecutive quarters while S&P profits trended higher before a selloff, the analyst noted.
Andrew Pauker, a Morgan Stanley strategist, said on Tuesday that the National Income and Products Accounts profits declined 5% in the first quarter, the first time since 2020, while the S&P earnings per share continued to trend higher for 2022-2023.
What To Look For: The analysts said, value has underperformed growth by -2%, quality has outperformed junk by 3.9%, and small caps have underperformed large caps.
The overweight sectors include Utilities, Health Care, and Real Estate, while the underweight sectors are Discretionary and Technology Hardware, as mentioned by Morgan Stanley.
Analyst Devin McDermott has announced an overweight rating on Exxon Mobil Corp XOM as its relative return to the S&P is 76%.
Stephen Byrd, another analyst at the firm, has put an overweight target on CenterPoint Energy Inc CNP as its relative return to the S&P is 19%.
Retail investor participation is at the 40th percentile relative to the last 5 years, and is down to 8.1% of total market volume, as stated by the Morgan Stanley analyst.
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