Despite a strong rebound from its fourth-quarter low, the S&P 500 Index (SPX) opened trading on Tuesday still 5.2% below the all-time record high set last September. "We think there is more downside in this correction," says Morgan Stanley. "We believe that our call for a boom/bust almost 3 years ago is well advanced. Many investors underappreciated how markets in 2017 were discounting 2018's coming boom and failed to see how markets in 2018 would discount the oncoming bust of 2019."

That's the sobering analysis of Morgan Stanley's U.S. equity strategy team, led by Michael Wilson, in their most recent Weekly Warm Up report. They expect the S&P 500 to fall to 2,600 in 2019, and perhaps even lower. That would be a decline of at least 6.7% from today's open, and a steeper 11.6% drop from September's high. (See table below.)

More Market Turmoil Ahead?

(3 Recent Corrections in S&P 500 Index)

  • Jan.-Feb. 2018 correction: -11.8%
  • Sept.-Dec. 2018 correction: -20.2%
  • From Sept. 2018 record high to forecast of 2,600: -11.6%

Sources: Morgan Stanley, Yahoo Finance; based on intraday prices.

Significance For Investors

With corporate earnings forecasts dropping, Morgan Stanley believes that stocks are "modestly overvalued" now. However, the firm adds, "with earnings likely to fall another 4-5 percent, we think there is more downside in this correction."

Rising costs are a major factor in this gloomy outlook for earnings. "The tax cuts enacted in late 2017 likely caused the Fed to tighten more quickly than they would have otherwise and also caused the US economy to overheat. This overheating created excesses in both the labor market and supply chains that now need to be wrung out of corporate costs," the report observes.

This has had a broader, negative impact. "Evidence of this cost rationalization is starting to show up in the data. Last week's jobs report was disappointing with one of the weakest payrolls numbers and the highest wage cost reading since the economic recovery began in 2009. Job cut announcements also spiked last week to the highest reading since July 2015. Finally, Amazon[.com Inc. (AMZN)] reportedly stopped ordering product from many of its wholesale vendors, perhaps as a sign they are trying to reduce inventory costs," Morgan Stanley elaborates.

The report's conclusion is simply this: the correction is not over until profit margin pressures stabilize. Meanwhile, the authors also predict that other negatives are likely to emerge, including cutbacks in "capital spending, which we think is the next major area of disappointment." The combination of rising business confidence and tax cuts led to a surge of capital investment in 2017 and the first half of 2018, but "this created excess in the short term." Technology companies, particularly software vendors, were notable beneficiaries of the spending boom, the report notes.

Morgan Stanley also observes that stocks which initially drop on lowered earnings guidance have tended to rebound several days later, a worrisome sign. "We think this kind of 'dip buying' on guidance signals confidence in a trough, but we aren't as sure," they say.

Looking Ahead

Morgan Stanley has been ahead of many firms on Wall Street in forecasting the sharp fall in earnings in 2019, giving their observations particular weight. "Defensives are likely to resume leadership," they say. Others share Morgan Stanley's view. Julian Emanuel, chief equity and derivatives strategist at BTIG, believes that stock market volatility will rise this year, and advises investors to prepare, per Business Insider.