A flare-up in the U.S.-China trade war rattled the markets on Monday, but a subsequent rally has trimmed the week-to-date loss for the S&P 500 Index (SPX) to just 0.2%, as of the close on Thursday, May 16, 2019. However, more trouble lies ahead, according to Mike Wilson, chief U.S. equity strategist at Morgan Stanley.

"Stocks have likely entered into a poor risk reward period due to the very low earnings growth we see over the next year and full valuations," he writes in a recent report. "Near-term earnings expectations remain too high by 5%-10%," he adds.

The table below summarizes four major concerns that Wilson and his team have right now.

4 Signs of More Market Trouble Ahead

  • Bullish sentiment is dangerously high.
  • The yield curve points to protracted stock market volatility ahead.
  • The risk of a recession increased sharply in the past month.
  • Earnings growth is more precarious than most observers think.

Source: Morgan Stanley US Equities Mid-Year Outlook, May 13, 2019

Significance for Investors

"Elevated bullish sentiment (87th percentile since 2005) leaves little room for sentiment-driven upside, particularly given lingering risk to earnings growth in 2019-2020, the unwillingness of the Fed to do an 'insurance cut,' and the recently rekindled risk of a trade conflict," the report observes. Investor sentiment is a classic contrarian indicator, taken as a negative signal when it is bullish, and a positive sign when it is bearish.

"Volatility may not subside as quickly as some think even if there is a proper de-escalation of these trade deal risks. We've highlighted for a long time that vol is likely to increase given the flattening of the yield curve over the past several years." The report elaborates that, while it is well-known that "a flattening yield curve is a leading indicator for the economic cycle," there also is "a very good leading relationship between the yield curve and the VIX." Moreover, the report adds, "Obviously, things get more difficult as we reach the end of the business cycle for the average company, and that leads to more stock market volatility."

While Wilson and his team have been predicting a corporate earnings recession, in which profits decline year-over-year in two or more consecutive quarters, Morgan Stanley's economists are not forecasting a general economic recession in the near future. "However, there are many signs that the risk of a recession in the next 12 months is increasing," the report warns. Indeed, in the past month the U.S. Cycle Indicator developed by Morgan Stanley's Cross Asset Research group "officially tipped over into the 'downturn' phase which has always preceded an economic recession."

Morgan Stanley's "earnings growth leading indicator" forecasts S&P 500 earnings over the next 12 months that are about 8% lower than the bottom-up consensus estimate. Wilson's team expects that 1Q 2019 will end with aggregate S&P 500 EPS being flat year-over-year, and their report says "We would not be surprised if both 2Q and 3Q turn out to be materially negative--i.e., worse than -5%--at this point."

Looking Ahead

"Price action and fundamentals support our 2,400-3,000 multi-year consolidation for the S&P 500," the report says. That is, Wilson's team expects the index to trade within this range for the next several years, with the two endpoints representing their bearish and bullish scenarios. The index closed at 2,876.32 on May 16, implying 16.6% downside and 4.3% upside from now in Morgan Stanley's estimation.