The S&P 500 could fall 17% as a decline in earnings means stocks will provide less protection against high inflation, Morgan Stanley says

• US stocks could fall an additional 17% from current levels as corporate earnings power declines, according to Morgan Stanley's Mike Wilson.
• The big concern is that stocks may not longer provide the hedge against inflation that many investors expect, Wilson said.
• "S&P 500 real earnings yield is the most negative since the 1950's," Wilson said.

The S&P 500 could see an additional 17% decline from current levels as stocks fail to provide the hedge against inflation that investors have grown to expect, Morgan Stanley's Mike Wilson said in a Monday note.

That's because the S&P 500's real earnings yield has plunged deepest into negative territory since the 1950's as inflation soars to 40-year highs.

"With inflation so high and earnings growth slowing rapidly, stocks no longer provide the inflation hedge many investors are counting on," Wilson said, adding that real earnings yield tends to lead real stock returns on a year-over-year basis by about six months.

That means stocks could still see significant downside from current levels as the S&P 500's real earnings yield plunges. At a minimum, Wilson expects the S&P 500 to trade to 3,800 in the near-term, which represents a potential decline of 8% from current levels.

But the S&P 500 could fall to as low as 3,460, which represents potential downside of 17% from current levels and is marked by the S&P 500's 200-week average. That grim scenario would be driven by the possibility of the S&P 500's forward 12 month EPS estimates begin to fall on margin and recession concerns, according to the note.

And that's a real possibility because supply chains disruptions have eased in the first-quarter and inventories are beginning to rise.

"These dynamic materializing at the same time demand is slowing from a rate of change standpoint increases the likelihood that excess inventory is being built right now in consumer goods channels — a risk to pricing," Wilson said.

On the flipside, if China continues to struggle grappling with an outbreak in COVID-19 cases, supply chains could once again tighten.

"Either way, it's not a bullish outcome for consumer goods stocks or others that have benefitted from these shortages and pricing power," Wilson said.

Wilson is reiterating his view long-held view that the stock market should be trending lower rather than higher due to the record surge in inflation, surging interest rates, and a precarious outlook for both consumers and corporations. For now, with the S&P 500 down about 14% year-to-date, Wilson's caution is proving warranted.