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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley CIO and chief U.S. equity strategist. Today on the podcast I'll be discussing our bullish mid year outlook and why stocks have been under pressure more recently. It's Tuesday, May 19th at 1:30pm in New York, so let's get after it. Every cycle has a moment when investors become so focused on the last risk that they miss the next opportunity. I think we're in one of those moments right now. The first half of this year has had a familiar feel to it. The market weakened under the surface well before the headlines got loud. Investors discovered the new risks after prices had already moved and sentiment got worse just as the forward setup was getting better. In other words, it's deja vu all over again, but with some important twists. The biggest twist is where we are in the cycle. Last year we were still coming out of the tail end of a rolling recession. Today we're in a rolling recovery and that's still underappreciated. This matters because it changes how we should interpret the correction. Earlier this year and the powerful rally in the first quarter, many investors looked at the S&P 500's less than 10% price decline and concluded the market was complacent. I think that really misses the point. Roughly half of the Russell 3000 saw drawdowns of 20% or more and the S&P 500 forward price earnings multiple fell by 18% from its peak as forward earnings continued to rise. That's not complacency, that's a market doing what it does best, discounting risk before the narrative catches up. And those risks were not small. We had private credit concerns and a major debate around AI disruption to labor markets as well as a new war that drove oil prices up by 100%. In many of the areas most directly exposed to these risks, the market delivered 40% plus corrections. So the provocative question I would ask now is this. What if the biggest risk from here is not being too bullish but being too cautious after the market has already done the work? We addressed these questions in our recently published Mid year Outlook. Specifically, we raised our 12 month S&P 500 price target to 8300 based solely on higher earnings forecasts? In fact, we assume some further valuation compression. We raised our S&P 500 EPS by approximately 5% as operating leverage from the rolling recovery, AI adoption, fiscal support and a capex cycle that continues to broaden. That earnings point is critical. In prior cycles, when oil shocks ended the business cycle, earnings were already decelerating or contracting outright before the shock hit. Today, the opposite is happening. Earnings are accelerating from already strong levels. First quarter median S&P 500 earnings surprise was 6%, the strongest in four years, and earnings revision breadth has moved back up to 22% from just 5% at the beginning of the reporting season. That's a very different backdrop than the traditional late cycle oil shock playbook. AI is another area where I think the consensus has evolved. The labor market disruption narrative has moved faster than the actual implementation. The enterprise application layer is still early, and for now AI looks more like a margin tailwind than a labor market wrecking ball. Companies are running leaner, hiring less, and beginning to quantify real benefits rather than simply firing everyone. While true adoption of this technology is likely to be slower than anticipated, the apprehension to over hire is real and that's driving higher profitability in an indirect way. Monetary policy and liquidity are still the main risks to this bull market rising unimpeded with the Fed becoming less dovish and liquidity needs rising, interest rates are on the rise and the equity rate correlation is negative again. The 4.5% level in the 10 year treasury remains important for valuations. We don't need Fed cuts for the equity market to work. History suggests that when earnings growth is strong and the Fed is on hold, returns can still be very solid. The real risk is liquidity, whether the Fed and Treasury underestimates how much capital the private economy now needs to fund investment and recovery. Ultimately, the Fed and Treasury have tools to address these liquidity needs, and they've been using them aggressively this year. However, these provisions can ebb and flow, and we are currently in a window where it's going to ebb, leaving stocks vulnerable in the short term. If the correction persists, investors should use that as an opportunity to add exposure to the parts of the market that benefit from a rolling recovery, specifically industrials, financials and consumer discretionary goods. The breadth of the earnings and capex cycle remains underappreciated, not to mention the recovery from the rolling recession that ended with Liberation Day a year ago. The bottom line is simple. The correction earlier this year was more significant than most appreciate in terms of valuation, and the earnings story is only getting better. The path won't be smooth, so use any corrections to position for the continued broadening in earnings that we believe will continue. Just remember, by the time the evidence feels obvious, the opportunity is usually gone. Thanks for tuning in. I hope you found it informative and useful. Let us know what you think by leaving us a review, and if you find thoughts on the market worthwhile, tell a friend or colleague to try it out and wish my wife a happy birthday.
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