Many strategists on Wall Street have are grown increasingly cautious on the market, citing stocks' breathtaking run, historically rich valuations and doubts about the Trump administration's ability to deliver.
Not Morgan Stanley (MS).
The firm's equity strategy team offers a bullish outlook for the next 12 months, offering a base case forecast in which the S&P 500 Index (SPX) reaches 2,700 a year from now, up 14.6% from its close on Friday. In fact, their bullish scenario calls for 3,000, an eye-popping gain of 27.4%. They open their April 10 report, which bears the headline Classic Late Cycle, with this comment on the current business cycle: "Although optimism is a late cycle phenomenon, history tells us the best returns often come at the end."
The Morgan Stanley strategists offer several reasons for their optimism.
Business Cycle "Trumps" Politics
While acknowledging that the pro-business agenda of President Trump has awakened "animal spirits" in the economy, the Morgan Stanley strategists feel that Trump has simply "turbocharged" a global business recovery that already has been underway since the first quarter of 2016. They note that one of the worst economic contractions in 30 years, as measured by U.S. GDP, bottomed out a year ago. Since then, their favorite economic indicators have been accelerating, including those capturing business conditions, business outlook and global trade.
As for the impact of the Trump agenda, Morgan Stanley identifies three groups of stocks that are most sensitive to various parts of it: banks (deregulation), small caps (tax reform) and deep cyclicals (infrastructure spending). But Morgan Stanley argues that all three began to outperform before the election, so they saw growth already underway even as the Trump and congressional Republican agendas now increase the odds for a "breakout" in growth versus the status quo.
Fundamentals That Matter
Morgan Stanley finds that positive surprises in economic data are coming in from major regions around the world, with the U.S. in the middle of the pack. They say that corporate earnings estimates and growth have been improving rapidly for over a year. As far as S&P 500 earnings are concerned, Morgan Stanley reports that the current 12-month forward consensus estimate is $135.10, and projects that this figure will reach $142 by August and $147 by December. They extrapolated based on current bottom-up earnings estimates and consensus earnings trends.
Valuation: The Most Important Call to Get Right
Morgan Stanley says that they expected market multiples (i.e., price-earnings ratios) to expand over the past year given their positive view of global growth, and that has indeed happened. Moreover, they do not believe that the current forward P/E of roughly 18 on the S&P 500 is excessive, in light of today's exceptionally low interest rate environment. Indeed, they find it conceptually invalid to compare P/E ratios today to, say, ratios in the early 1980s when interest rates were in double digits.
Morgan Stanley prefers a metric called the Equity Risk Premium (ERP), which captures the incremental returns on equities versus that on U.S. government bonds. They calculate that return as being about 330 basis points (bps) today, versus a 40-year average of about 175 bps. Looking at 100 years of history, they calculate the average value of ERP based on 12 months of trailing earnings as 242 bps. In fact, they note that ERP serves as an indicator of valuation bubbles when it plunges significantly into negative territory, as it did with the 1987 market crash and the Dot.com Bubble of the late 1990s.
Morgan Stanley's base case forecast of 2,700 on the S&P 500 is the result of the 12-month forward EPS reaching 142 in August, and the market P/E expanding to 19. The P/E, in turn, results from their forecasts of ERP rising to 250 bps and a yield on the 10-year U.S. Treasury Note of 2.75% at that time.
In this environment, Morgan Stanley is overweight in financials, industrials, energy and technology. They expect financials to benefit more from deregulation, cost cutting and operating leverage than from interest rate increases. Global economic growth should help industrials while energy is fairly valued and tends to perform well late in economic cycles and offers a hedge against geopolitical risk, when oil prices spike. Morgan Stanley says technology has the best and broadest earnings momentum of all sectors. (For more, see also: Banks' Job Bloodbath Will Continue in 2017.)
The firm is underweight in real estate, telecom and consumer staples. REITs should suffer in a rising interest rate environment, telecoms from stiff competition with severe price pressures, and consumer staples, which were beneficiaries of QE, from deteriorating earnings. (For more, see also: These Mall REITs May Turn Into a Nightmare.)
The Contrary View
Morgan Stanley's bullish view runs counter to other, more pessimistic, outlooks that we have reported on recently. These include: unimpressive consensus forecasts of U.S. GDP growth. (For more, see: Will 'Animal Spirits' Fire Up the U.S. Economy?), portfolio managers' fear that equity valuations are excessive while investors flee equities for fixed income (see: Why a 10% Stock Correction May Be Good), growing doubts about the ability of the Trump agenda to get passed (see: Trump's Infrastructure Plan May Hit a Pothole, and high market valuations relative to GDP (see: The Single Number Preventing a Trump Bull Market.)