A surprisingly good start for the U.S. stock market in 2023 is likely to fade this week as the Federal Reserve is set to announce its eighth consecutive rate hike at the conclusion of its policy meeting, according to Morgan Stanley’s Michael Wilson.
“We think the recent price action is more a reflection of the seasonal January effect and short covering after a tough end to December and a brutal year,” wrote a team of strategists led by Wilson, Morgan Stanley’s chief equity strategist. “The reality is that earnings are proving to be even worse than feared based on the data, especially as it relates to margins.”
January started on a high note for stock-market investors, with three major equity indexes on pace to book strong monthly gains. As of Friday, the S&P 500
was up 4.6% in the first four weeks of January, while the Dow Jones Industrial Average
advanced 1.7%. Tech stocks were having their best January in decades, with the Nasdaq Composite
up 8.9% on the month as of Monday, on track for its best January performance since it notched a 12.2% gain in 2001, according to Dow Jones Market Data.
However, Wilson and his team were surprised by the magnitude of the recent advance. It is “just another bear-market trap” and “all the good news is now priced,” which means “the reality is likely to return with month-end, and the Fed’s resolve to tame inflation,” they wrote in a Monday note.
See: What stock-market investors need to know about the ‘January Indicator Trifecta’
The “January Effect” is a seasonal tendency for small-cap stocks to rally in the month following December’s tax-loss harvesting in generally illiquid equities. Theoretically, investors could use those funds to rebuy new positions in January, which can contribute to the monthly rally.
Other possible explanations include “window dressing,” a practice performed by institutional investors to buy more shares of top-performing stocks by the end of the year to improve the appearance of their fund’s performance before presenting it to shareholders.
Another is investor sentiment, with investors tending to be more optimistic about the future as a new year begins.
Morgan Stanley’s strategists warned at the start of the year that a recession shock in 2023 could drive another 22% drop for stocks, and they expected the large-cap index to finish the year at 3,900. The S&P 500 ended 52 points lower, or 1.3%, to 4,018 on Monday.
See: It’s a key week for the stock market. If you’re not nervous, you should be, this global strategist warns.
Moreover, Wilson argued that investors seem to have forgotten the cardinal rule of “Don’t Fight the Fed.” He said the upcoming FOMC meeting, which concludes on Wednesday, will serve as a reminder.
The central bank is widely expected to raise its target federal-funds rate by 25 basis points, to a range of 4.5% to 4.75%. Traders now place a 98% probability of that size hike, according to the CME’s FedWatch tool.
So far, however, the Fed has yet to signal a willingness to hit the brakes and truly pivot to a more dovish stance. That, coupled with the reality of the worst earnings recession since 2008, are “being mispriced once again, in our view,” said Wilson.
See: The Fed and the stock market are on a collision course this week. What’s at stake.
Morgan Stanley’s 2023 base case forecast for S&P 500 earnings per share (EPS) is $195, while their bear case forecast is $180. EPS refers to net income divided by the number of shares outstanding, and could indicate how much money a company makes for each share of stock.
Wilson and his team said they are now leaning more toward their bear case of $180 based on the margin degradation. “We think it’s important to note that typically when forward earnings growth goes negative, the Fed is actually cutting rates. That’s not the case this time around, (which is) an additional headwind for equities.”