The S&P 500 could fall another 22% and investors' view of more downside for stocks is too mild, Morgan Stanley says

• The S&P 500 could sink by more than investors anticipate, Morgan Stanley warned on Monday.
• The benchmark is likely to drop about 22% from current levels to around 3,000.

Investors should brace for an much bigger decline in the US stock market than they are expecting for 2023, Morgan Stanley told clients Monday.

Consensus views are forming a line behind the idea that the economy is facing a high risk of recession in the first half of this year followed by recovery in the second half.

"Our concern is that most are assuming 'everyone is bearish,' and, therefore, the price downside in a recession is also likely to be mild (SPX 3,500-3,600). On this score, the surprise might be how much lower stocks could trade (3,000) if a recession arrives," wrote Michael Wilson, chief US equity strategist at Morgan Stanley, in a note.

A level of 3,000 would mark a roughly 22% decline from current levels.

The equity market is vulnerable to weaker corporate earnings and a Federal Reserve that is set to stick firmly with battling inflation largely though raising interest rates. Investors are largely pricing in expectations for the Fed to raise interest rates through May to as high as 5.25% and then begin reducing them later in the year.

The S&P 500 tumbled 19% in 2022 but has been pushing higher as 2023 trade gets underway. The index along with the Nasdaq Composite last week swerved away from a fifth straight week of losses, sparked in part by easing wage growth seen in the December jobs report. A slide in bond yields after separate services-sector data from the Institute for Supply Management also contributed to sending stocks higher Friday.

Inflation expectations improved slightly after the jobs report, said the investment bank.

However, this "ignores the ramifications of falling prices on profit margins, which is likely to outweigh any benefit from the perceived Fed dovishness equity investors are dreaming about later this year," said Wilson. "Furthermore, we highlight that the drastic ISM Services miss that set off the bond rally on Friday sends an ominous signal for growth."

The ISM's report showed services activity shrank for the first time since May 2020. The bond rally suggested investors see slowing economic growth as laying the groundwork for the Fed to claw back its aggressive interest rates increases. Seven rate hikes were issued last year.

The S&P 500 at 3,900 is a "good level to be selling into again in front of what is likely to be another weak earnings season led by poor profitability and the broader introduction of 2023 guidance," said Wilson. The bank's base case is 3,900 for the index this year and its bull case is 4,200.

The S&P 500 was pushing its rally into a second consecutive session on Monday, up by more than 1% to around 3,945.

"The bottom line, we don't think a 3,500-3,600 S&P 500 is consistent with the consensus view for a mild recession. That is one way the consensus could be right directionally, but wrong in terms of magnitude," said Wilson.