- Morgan Stanley's top equity strategist Mike Wilson is staying bearish on the stock market despite the latest rally.
- Wilson pointed to the potential for disappointing earnings and a tightening Fed as reasons investors should be cautious.
- "We think the recent collapse in breadth is the market's way of warning us we are far from out of the woods with this bear market."
Investors are poised for disappointment amid the ongoing stock market rally because earnings expectations are too optimistic, according to Morgan Stanley's top equity strategist Mike Wilson.
The S&P 500 is up 8% year to date, and the Nasdaq is up 16%. But earnings estimates remain too high even after they've been consistently moving lower, and that they are "likely to fall rapidly as revenue growth is the next shoe to drop," he said in a Monday note. Currently, consensus first-quarter estimates are for 5% sales growth and an 8% decline in earnings.
And while first-quarter results have so far proven to be better-than-expected, Wilson still sees them coming down "gradually, then suddenly."
He believes revenue growth is going to disappoint investors based on recent soft readings in inflation, which signals a decline in demand.
"We would caution those cheering the softer-than-expected inflation data last week. Falling inflation, especially for goods, is a sign of waning demand, and inflation is the one thing holding up revenue growth for many businesses," Wilson warned.
And once revenues start to fall, profit margins will erode, which should help send S&P 500 earnings-per-share results to Wilson's below-consensus estimate.
"If/when revenues begin to disappoint, that margin degradation can be much more sudden, and that's when the market can suddenly get in front of the earnings decline we are forecasting," he explained.
There's one more factor causing Wilson to have a cautious view on equities despite this year's market rally: the Federal Reserve's ongoing policy of high interest rates.
While inflation has cooled off sharply, it's still above the Fed's long-term target of 2%. That could cause the Fed to continue with rate hikes and keep rates higher for longer, dragging on stock prices.
"The Fed's favorite measure of core services inflation remains too high for its liking. In some ways, it feels like our original thesis of Fire and Ice could be back in play with the Fed forced to stay with its tightening path into a slowing economy and earnings," Wilson said.
The problem can compound if second-quarter GDP growth falls below 0%, as Morgan Stanley's economists expect, as that would put pressure on corporate earnings, especially if revenue disappoints as Wilson expects.
"If there is one thing that can throw cold water on the large mega cap rally it's higher yields due to a Fed that can't stop hiking as soon as perhaps some investors are expecting... We think the recent collapse in breadth is the market's way of warning us we are far from out of the woods with this bear market," Wilson said.