Big Short of Morgan Stanley: Why We Are More Pessimistic About US Stocks Than Wall Street

The divergence between Morgan Stanley and its Wall Street peers on the 2023 US stock market earnings is widening. In its recent strategic and economic outlook, Morgan Stanley lowered its 2023 US stock EPS (earnings per share) forecast to a level far below the market's general expectations, while other major Wall Street banks raised their forecasts.

Why is Morgan Stanley more pessimistic than Wall Street about the US stock market? Last week, Mike Wilson, a strategist at Morgan Stanley and one of the most pessimistic voices on Wall Street, explained the issue in an article.

Wilson said that in recent years, Morgan Stanley's overall view of the market has been influenced by the bank's "hotter but shorter" cycle framework theory, which means that the current economic cycle is hotter but shorter than the cycle of the past 50 years.

Morgan Stanley believes that this cycle has many similarities to the post-World War II period.

First and foremost, the excess savings accumulated during World War II and the COVID-19 lockdown period were released into the economy when supply was restricted, driving fundamentals and asset prices back to the previous cycle's highs at the fastest pace in history.

In the current economic cycle, the surge in inflation in 2021 and the prosperity of the US stock market have ultimately led to the most intense rate hike cycle by the Federal Reserve in 40 years. Regarding this, Wilson said:

At the time, many were surprised by the stock market's prosperity and the Fed's reaction. Looking back now, we suspect many will be surprised again by the depth of the income decline in 2023 and the subsequent rebound in 2024-2025.

Wilson believes that the US stock market is in a downturn period of the earnings cycle, but it has not yet been priced by the market. As inflation continues to decline in a high-interest environment, profit margins and income will rapidly decline.

Morgan Stanley said that many investors are making two key assumptions that may pose risks:

First, the impact of rate hikes on economic growth is over;

Second, sectors such as cyclical consumer goods, technology, and communication services experienced profit declines last year, and other sectors in the market may be affected, but profit growth will still accelerate. In fact, regaining speed has now become a consensus expectation.

Morgan Stanley strongly opposes the above two assumptions. Wilson said:

We believe that this consensus exists mainly because some large companies are more optimistic about the second half of 2023, and AI and its significance for economic growth and productivity have created new excitement.

Some individual companies will undoubtedly achieve accelerated growth this year by increasing AI investment, but we believe that this is not enough to completely change the trajectory of the overall trend of cyclical earnings.

On the contrary, recent revenue growth of US stock companies has remained flat or slowed down, and companies that still decide to invest in AI may face further profit pressure.

Morgan Stanley pointed out that in the past 70 years, the growth rate of US stock earnings has typically bottomed out at a level very close to -16%, which is also Morgan Stanley's forecast for this year's decline in US stock earnings based on its earnings model. **

Finally, Wilson pointed out that the profitability quality measured by the ratio of net income to cash flow has recently reached the lowest level in the past 25 years.

We believe this is another warning signal that as the cycle turns and accounting policies shift to more conservative assumptions, profit growth will further deteriorate. We further note that the excess income during the epidemic and these low-quality profits have a broad foundation.

For the performance of US stock earnings next year, Wilson is obviously more optimistic.

As we enter 2024, we see a healthier profit environment facing the market, and we predict that earnings per share will increase by 23% YoY in 2024, which also conforms to historical experience, with (US stocks) entering a year of profit decline and then turning to profit growth.