The rally in stocks will trick investors into thinking the bear market is over, but there's still a case for the S&P 500 to fall another 26% next year, Morgan Stanley's Mike Wilson says

• Stocks rallying on hopes of the Fed pausing rate hikes will fool investors into thinking the bear market is over, Morgan Stanley's Mike Wilson said.
• But stocks could be hit with an earnings recession next year, he told Bloomberg, warning a 26% drop in the S&P 500 was still possible.

The current rally in stocks will trick investors into thinking the bear market is over, but there's still a case for the S&P 500 to fall another 26% next year, according to Morgan Stanley's chief US equities strategist Mike Wilson.

The top portfolio strategist according to Institutional Investor spoke a day after Federal Reserve Chairman Jerome Powell signaled rate hikes will slow as soon as this month.

"Powell's commentary is right in line with what we've been saying, which is that they're going to pause probably in January and the market is getting in front of that. This is a classic Fed pause stock market rally," Wilson said in an interview with Bloomberg TV on Thursday.

The Fed chief's remarks led stocks to soar on Wednesday, as tech and other growth stocks have been hammered by Fed rate hikes all year.

That means the Nasdaq and other heavily-shorted stocks could be leading the new market rally, but investors are still in a bear market, even if gains last through December, Wilson warned.

"This rally will go further and will probably drag people back into thinking that this bear market is over," he added.

Stocks gained momentum after the October inflation report clocked in below-expectations, spurring hopes the Fed will ease up on its monetary tightening and give equities more room to breathe.

But Wilson has argued that corporate earnings are still 20% too high and will fall next year, causing stocks to bottom in the first half of 2023.

Inflation is also set to slow to 2%-3% next year, which is good for the economy but spells trouble for stocks. That's because falling inflation will weaken profit margins, Wilson said, adding that a moderate recession that tanks the S&P 500 to 3,000 in the first half of next year was "not really a stretch."

That bear-case scenario represents a 26% drop from current levels, in line with other strategists who have warned of a big falloff in equities next year as the US flirts with a possible recession.

Bank of America said a US recession could ravage the stock market and send stocks plunging 24% next year, and JPMorgan warned that the S&P 500 could soon retest a low of 3,577, a 12% decline from current levels.