Why Equity Markets May Be Stronger Than You Think - Thoughts on the Market

Summary

Podcast Summary: "Why Equity Markets May Be Stronger Than You Think"

Podcast Information

Title: Thoughts on the Market
Host/Author: Morgan Stanley
Episode: Why Equity Markets May Be Stronger Than You Think
Release Date: June 2, 2025

Overview In the June 2, 2025 episode of "Thoughts on the Market," Morgan Stanley's Chief Investment Officer and Chief U.S. Equity Strategist, Mike Wilson, provides an insightful analysis of the current state and future prospects of the U.S. equity markets. Despite a volatile first half of the year, Wilson maintains a constructive outlook for U.S. equities over the next twelve months, emphasizing the resilience and underlying strengths that may not be immediately apparent to market participants.

Maintaining the S&P 500 Price Target Wilson begins by addressing the firm's steadfast commitment to the S&P 500's year-end price target of 6,512, despite significant volatility in the initial five months of the year. He explains that this confidence is rooted in the expectation of a challenging first half for U.S. stocks, followed by a more favorable second half.

"We've maintained our 6,512 month price target for the S&P 500 this year despite what has been a very volatile first five months both in terms of news flow and price action." [00:30]

This strategic stance is influenced by anticipated policy directions under the new administration, which Wilson believes may have growth-negative implications. Key policy areas impacting this outlook include immigration enforcement, spending cutbacks, and tariffs. Additionally, a slowdown in AI capital expenditures (Capex) after rapid growth the previous year is expected to dampen economic growth and earnings revisions in the short term.

Market Reactions and Capitulation Selling Wilson highlights an unexpected development related to the implementation of tariffs on Liberation Day, which caught most market participants off guard, including Morgan Stanley. This event acted as a catalyst for widespread capitulation selling among institutional investors, leading to a significant drop in equity prices.

"The way in which tariffs were rolled out on Liberation Day was a shock to most market participants, including us, and served as the perfect catalyst for what can only be described as capitulation selling by many institutional investors." [02:15]

However, this capitulation has paved the way for a reflexive snapback in equity prices. Several factors support this rebound, including positive changes in policy, earnings revision breadth, favorable financial conditions, and a weaker U.S. dollar.

Earnings Outlook and Valuations A central theme of the discussion is Morgan Stanley's positive earnings outlook, projecting high single-digit growth for both the current year and the next. Wilson addresses pushback regarding this optimistic forecast and the belief that valuations can sustain elevated levels at 21.5 times forward earnings.

"The main pushback to our view centers on our constructive earnings outlook for high single digit growth both this year and next, and our view that valuations can remain elevated at 21.5 times forward earnings." [03:10]

Key points supporting this stance include:

Earnings Estimates: Current calendar year earnings estimates reflect only a mid-single-digit percentage adjustment, aligning with consensus forecasts.
Leading Earnings Indicator: Projections indicate a steadied growth trajectory in the high single-digit range over the next twelve months.
Additional Tailwinds: Factors such as a weaker dollar, elements of the tax bill, and AI-driven productivity enhancements are expected to provide incremental benefits to earnings not fully captured in current models.
Sector Resilience: The phenomenon of rolling recessions across various sectors over the past three years has simplified growth comparisons.
Earnings Revisions Breadth: There is a notable inflection in the rate of change for earnings revisions breadth, moving higher from a prolonged downturn in valuations.

Wilson underscores the rarity of seeing multiple compression in price-earnings multiples when earnings growth exceeds the long-term median of 7% and the Federal Funds rate declines year-over-year. Historical data supports the expectation that under these conditions, price-earnings multiples have expanded 90% of the time by approximately 9% over twelve months.

"Our work shows that if earnings growth is above the long term median of 7% and if the Fed Funds rate is down on a year over year basis, it's very rare to see multiple compression. In fact, price earnings multiples have expanded 90% of the time under these conditions to the tune of 9% over a 12 month period." [03:50]

As a result, Morgan Stanley adopts a conservative forecast, anticipating the S&P 500's price-earnings ratio to remain stable at current levels over the next year.

Historical Comparisons and Risk Premium Wilson draws parallels between the current market environment and past financial shocks to contextualize the resilience of equity markets. He notes that the equity risk premium experienced post-Liberation Day mirrored levels seen after the 9/11 attacks in 2001 and even surpassed those during the Long-Term Capital Management crisis in 1998. Historically, such elevated risk premiums have led to significant corrections followed by robust market recoveries within a year.

"Both episodes resulted in 20% corrections to the S&P 500, much like we experienced this year, only to be followed by very strong equity markets over the next year." [04:05]

Conclusion Mike Wilson reaffirms his conviction in Morgan Stanley's earnings forecasts, anticipating high single-digit growth for the current and following year. He also maintains that valuations can stay elevated amidst a classic late-cycle economic expansion characterized by slower growth, which typically prompts interest rate reductions from the Federal Reserve. This positive outlook is grounded in a combination of strong earnings projections, supportive financial conditions, and historical precedents indicating market resilience following significant corrections.

"The bottom line is that I remain convicted in both our earnings forecast for high single digit earnings growth for this year and next, and my view that valuations can remain elevated in this classic late cycle expansion of slower economic growth that typically elicits interest rate cuts from the Fed." [04:10]

Final Remarks Wilson concludes the episode by encouraging listeners to engage with Morgan Stanley for further insights and to share their thoughts through reviews or by recommending the podcast to peers.

Disclaimer At the end of the episode, a disclaimer is provided emphasizing that the content is for informational purposes only and should not be construed as financial, tax, or legal advice. It also notes that the information does not consider individual financial circumstances or objectives and may not be suitable for all listeners.

"The proceeding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for you." [04:22]

Key Takeaways

Stable S&P 500 Target: Morgan Stanley maintains a year-end price target of 6,512 for the S&P 500 despite first-half volatility.
Policy Impact: New administration policies on immigration, spending, and tariffs expected to influence economic growth and earnings.
Capitulation Selling: Unexpected tariff implementation led to significant institutional selling, setting the stage for a market rebound.
Positive Earnings Outlook: High single-digit earnings growth projected for this year and next, supporting elevated valuations.
Historical Resilience: Past market corrections under similar conditions have been followed by strong recoveries.
Conservative Valuation Forecast: Expectation for the S&P 500's price-earnings ratio to remain stable over the next twelve months.

This comprehensive analysis by Mike Wilson provides investors with a nuanced understanding of the current market dynamics and the factors underpinning Morgan Stanley's optimistic outlook on U.S. equities.

Transcript

A (0:00)

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 discuss where there's the most pushback to our mid year outlook and why I remain convicted in our generally constructive view on US equities for the next 12 months. It's Monday, June 2nd at 11:30am in New York, so let's get after it. To briefly summarize our outlook, we've maintained our 6,512 month price target for the S&P 500 this year despite what has been a very volatile first five months both in terms of news flow and price action. Part of the reason we didn't change this view stems from the fact that we expected the first half to be challenging for US Stocks but to be followed by a more favorable second half. Much of this was related to our view that the new administration would pursue the growth negative part of their policy agenda. First, this played out with their focus on immigration enforcement and spending cutbacks and tariffs. In addition to these policy adjustments, we also expected AI Capex to decelerate in the first half after such fast growth last year. All these factors conspired to weigh on both economic growth and earnings revisions. Second, the way in which tariffs were rolled out on Liberation Day was a shock to most market participants, including us, and served as the perfect catalyst for what can only be described as capitulation selling by many institutional investors. That capitulation has set the stage for the very reflexive snapback in equity prices that is also supported by a positive rate of change on policy, earnings revision breadth, financial conditions and a weaker US Dollar. The main pushback to our view centers on our constructive earnings outlook for high single digit growth both this year and next, and our view that valuations can remain elevated at 21.5 times forward earnings. On the earnings front, our calendar year earnings estimates already incorporate a mid single digit percent hit the bottoms up consensus forecasts. Second, our leading earnings indicator which projects earnings per share growth 12 months out, is suggesting a sideways consolidation in growth in the high single digit range over the next year. Third, a weaker dollar elements of the tax bill and AI driven productivity should be incremental tailwinds for earnings that are not in our model. Fourth, we've experienced rolling recessions for many sectors of the private economy for the last three years, which makes growth comparisons easier. Finally, and most importantly, the rate of change on earnings revisions breadth has inflected higher from a very low level after a year long downturn on valuation. Our work shows that if earnings growth is above the long term median of 7% and if the Fed Funds rate is down on a year over year basis, it's very rare to see multiple compression. In fact, price earnings multiples have expanded 90% of the time under these conditions to the tune of 9% over a 12 month period. Therefore, in many ways we're being conservative with our forecast For S&P 500's price earnings ratio to remain flat at current levels over the next year. With respect to our favorite valuation metric, the equity risk premium, it's interesting to note that in the week following Liberation Day, the equity risk premium reached the same level we witnessed in the aftermath of the 911 shock in 2001 and even exceeded the risk premium reached during the Long Term Capital management crisis in 1998. Both episodes resulted in 20% corrections to the S&P 500, much like we experienced this year, only to be followed by very strong equity markets over the next year. The bottom line is that I remain convicted in both our earnings forecast for high single digit earnings growth for this year and next, and my view that valuations can remain elevated in this classic late cycle expansion of slower economic growth that typically elicits interest rate cuts from the Fed. 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.