Over the past year, Morgan Stanley’s Michael Wilson has done something virtually none of his colleague have been able to do: he called market moves correctly before they happened and also timed the market’s inflection points with uncanny precision: turning bullish at the depths of the March crisis, when most of his peers were apocalyptic, then remaining bullish until just over a month ago, when he warned “brace for a very difficult trading environment over the next five weeks” – which followed with the early September tech dump – and then two weeks after he again correctly predicted that US stocks were due for their second 10% correction in as many months as “investors were a bit too complacent on the uncertainty surrounding the election outcome, unlikely passage of a fiscal stimulus before the election and second wave of Covid-19”, the S&P 500 has indeed fallen 9% while the Nasdaq and Russell 2000 have fallen 10% and 7%, respectively.
He was, again, right.
Then, just last Monday, he reversed his bearish bias, when as we reported he predicted that “the correction we expected is now mostly finished and adding to equities on further weakness this week is recommended.”
Since then, the S&P is up +13.5% to a new all time high, the Nasdaq is up +10.8% also to a record high, and after today’s Pfizer news, the Russell has exploded 16% higher.
In short, he was right again.
In his latest note, which was published before this morning’s Pfizer news, Wilson writes that he has remained a “committed bull” based on his thesis since late March that “bear markets end with recessions as new bull markets begin.” As he adds, “when bull markets simultaneously begin with a new economic cycle, they typically last for years, not months or quarters. As such, we believe this bull market has a long way to run both in time and price. Our calls for a 10% correction in August and then again in October were under the guise that we needed a pause / consolidation of the extraordinary gains during the first stage of this new economic cycle and bull market.” He quantifies his bullish view by saying that his “S&P 500 range of 3150-3550 is based on both technical and fundamental analysis” although with the S&P now trading well above this bogey, he will probably have to reassess, although in light of the positive covid news, it is likely that he will materially increase his price target.
Following this intro, Wilson takes a well-deserved victory lap writing that in last week’s note, “we recommended adding equity risk given we were so close to the low end of our range. While that advice worked well, we must admit we didn’t expect to return to the top end of the range so fast.”
The reason Wilson thinks markets reacted so quickly and severely is that they were not expecting the election to result in a divided government outcome. More specifically, that the Republicans would hold the Senate. At the end of the prior week, markets had (appropriately) started to contemplate what a big blue wave might mean for equity and fixed income markets – i.e. that maybe it wouldn’t be so great, at least initially.
To be sure, even Morgan Stanley was among those who warned that the lack of a blue wave would be bearish:
We held that view in our election preview note published on October 19 with our macro research colleagues (Exhibit 1).
Interestingly, our probability weighted forecast for the S&P 500 going into the election was 3222, which is almost exactly where the S&P 500 bottomed on Friday, October 30th. In other words the market was more properly priced for the most likely probabilities of the various outcomes as markets opened last Monday. Hence our advice to start adding risk in last week’s note.
What’s next? Well, if one excludes today’s Pfizer news, Wilson writes that aspects of the actual election result remain unclear: “While it appears Joe Biden has the requisite electoral college votes to be the next President of the United States, this outcome is being litigated by President Trump, a process that could drag out for weeks even if it doesn’t change the outcome. More importantly for markets, the Senate now stands at 50 Republican and 48 Democrat seats and the uncertainty as to the final 2 seats will have to wait until the runoff elections in Georgia on January 5th.”
While Wilson agrees with most clients that “when all the dust settles, we should have a Democrat President with a Republican Senate and Democrat House” he recognizes the consensus hasn’t exactly hit the nail on the head with regard to election outcomes. Wilson also notes that at current prices, a divided government outcome appears fairly priced now. Furthermore, it is worth remembering that we won’t know the official outcome for another 8 weeks, a period that encompasses the all-important year-end measuring stick for investment managers, which can lead to big positioning swings, or higher volatility
And while the market may decide it already knows the outcome and look forward to next year, Wilson recommends “investors keep their head on a swivel, as this market likely has a few more cheap shots in it before year end.”
Here Wilson takes a detour in delineating covid-linked risks, although judging by today’s market reaction those can be discounted. In any case, according to Wilson, “in addition to the election uncertainty that still remains, we are now in the midst of the second wave of the COVID-19 virus. Europe has reacted to this second wave with aggressive lockdowns and the US may do the same thing in some states as case counts rise. Such a risk is not priced at current levels, in our view. In short, it’s not clear that the consolidation that began in August is over.”
One can naturally counter here that markets are now openly ignoring any near-term covid infection spike risks by pricing in the inevitable vaccine, which while delayed in 2020 will surely be rolled out in early 2021:
That said, Wilson then says that he relies on technical analysis to tell us what’s next: “we highlight an interesting pattern that has now developed in the S&P 500 known as a wedge or triangle (Exhibit 2). As already noted, since peaking in early August, we have experienced two separate 10 percent corrections and recoveries. With last week’s strong rebound, the market finds itself at a critical juncture. Can it break through the top end of the wedge in Exhibit 2, or not? We make no prediction but we are leaning toward another rejection here at resistance. As such, we will let the market speak before recommending investors add more risk at prices that are far less attractive than last week.”
Wilson’s bottom line, “we like it when technicals line up with the fundamentals and this wedge is a perfect representation of the current situation – balancing the near-term uncertainties that remain in 2020 with the increasingly bullish outlook for 2021. As such, we continue to be bullish over the next 6-12 month but very cognizant and disciplined about price in the short term.”
Finally, in terms of actual trades, even before today’s Pfizer news, Wilson said to overweight procyclical sectors, and growth at a reasonable price (GARP) stocks while remaining careful with high quality defensive or secular growth stocks that may be overpriced for such an outcome:
“As we have shown many times, perhaps the best representation of our viewpoint can be seen in the performance of an equal weighted S&P 500 over a market cap weighted version (Exhibit 3) as well as small caps over large (Exhibit 4). These remain two of our highest conviction calls over the next 6-12 months.”
Considering the S&P is now well above 3,600, or the upper bound when the Morgan Stanley strategist wrote the note, and that small caps are soaring while defensive and tech stocks are barely in the green, it appears that Wall Street’s most accurate strategist will be correct once again.