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- Morgan Stanley's top US equity strategist says investors will have a chance at bigger-than-usual rewards because of the elevated equity risk premium - which he expects to decrease in the months ahead.
- Wilson says that makes this a rare moment where the premium is high, and it's happening even though the Federal Reserve is actively shoring up the economy and markets, reducing risks.
- Wilson also raised his year-end targets for the S&P 500 and is advising investors to buy stocks when the market declines because he's confident they're going to head higher in the coming months.
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If wise investing involves being fearful when others are greedy and greedy when others are fearful, Morgan Stanley chief US equity strategist Michael Wilson is telling investors now is a great time to get a little more greedy.
He's essentially arguing that investors are more fearful than they should be. The evidence of his argument is the elevated equity risk premium, a measurement of how much additional reward investors should expect for accepting an increased level of risk.
After everything that's happened in the last two months, that premium is understandably higher than normal. But Wilson says the Federal Reserve's dramatic steps to shore up the economy - which has largely been frozen in place by measures that are intended to halt the spread of COVID-19 - have removed many of the dangers for stocks.
That means the elevated level of reward investors can reap won't last long.
"If there is one lesson we have learned during the financial repression era it's that when risk premium appears, you better take it quickly before it disappears," he wrote in a note to clients.
By way of illustration, Wilson says the premium peaked at 700 basis points in March 2009, when the market hit its financial crisis low point. Just three months later it fell to a range of 300 to 400 basis points, which became its home range for the entire length of the bull market.
The same pattern will play out by the end of the year, he says. That's because, in spite of everything that's changed in the last few months, the Fed's role hasn't. It's still suppressing volatility and keeping rates extremely low.
In the wake of the Fed's most recent measures, Wilson raised his year-end targets for stocks. He now expects the S&P 500 be at 3,000 at the end of the year. That's still 11% off its all-time high from February 19, but represents a 34% rally from the index's closing low on March 23.
In Wilson's bull case, he says the benchmark index could close the year at 3,250, slightly above where it finished 2019. His bear case, which he considers less likely, calls for another slump to 2,500.
But he's advising investors to act fast in either event, and that it's time to start buying on the dips again to take advantage of momentary sell-offs.
"Pullbacks should be bought," he wrote. "Investors should not get overly complacent and expect the market to hand us another great buying opportunity on a silver platter."
Outlined below is his three-part strategy for investors looking to take advantage of the opportunity that still exists.
(1) Bad is good
The Fed's efforts to keep at-risk companies afloat will keep some of those businesses out of bankruptcy, and Wilson says that makes those "bad actors" some of the biggest prospective winners. So he's advising investors to make sure they buy a mix of those along with inexpensive high-quality companies.
"The bad actors of the last cycle are getting bailed out, which could ultimately limit the malaise we typically get in a recession," he said."The worst stocks will likely have the biggest recoveries."
(2) Small caps
Overlapping with Wilson's higher-risk recommendation, he's telling investors it's a good time to buy small-cap stocks. They underperformed their larger rivals throughout the 2010s bull market and that trend only grew more dramatic in the last two years. Wilson says they've taken the lead recently, but have a ton of ground to make up.
"Small caps typically lead coming out of a recession," he said. "We think last week's relative outperformance represents the kick off move to what could be a durable new trend."
Combined, those two tips amount to a bet on the new economic cycle. Wilson says that's a better move than paying a high price for traditional defensive stocks.
For those looking for broad exposure to small-cap stocks, the iShares Russell 2000 ETF tracks a large universe of small growth equities.
(3) Value over growth
Nobody expects much growth out of US companies in 2020, but Wilson says expectations aren't falling in an equal way. The prices of slower-growing value stocks largely reflect the decline, he writes, while growth stocks - which have a stronger level of growth to begin with - are priced in a much more optimistic way.
Wilson argues that that means value stocks have more room to beat expectations and reap the rewards, while growth stocks are likely to come under pressure as their profit and sales estimates get cut.
Traders seeking exposure to a wide range of value stocks should consider the Vanguard Value ETF.
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