Profit forecasts are too high, says Morgan Stanley

The odds of a year-end rally in US stocks are fading as investors face a multitude of risks from elevated profit estimates to the Federal Reserve’s policy tightening, according to Morgan Stanley’s Michael Wilson.

The strategist — among the most bearish voices on US stocks — said he “would not be surprised” to see further declines in the S&P 500 with “earnings expectations likely too high for the fourth quarter and 2024, and policy tightening likely to be felt from both a monetary and fiscal standpoint.”

Wall Street analysts expect S&P 500 firms to post an earnings decline of 1.1% for the third quarter, before a rebound of 5.2% in the October-December period, according to data compiled by Bloomberg Intelligence. Forward 12-month estimates have also risen close to a record high.

Wilson’s pessimistic view has been somewhat vindicated, with the S&P 500 tracking its third straight monthly decline on worries of higher-for-longer interest rates. On Friday, the benchmark closed at 4,224 points, below its 200-day moving average for the first time since March. That’s considered a key technical support level and used by traders to assess whether the longer-term trend is up or down.

The combined outlook for earnings, valuations and policy means that the S&P 500 “will have a hard time” getting back above 4,300 to 4,400 points — which were previously considered levels of tactical support, Wilson said. The strategist has a year-end target of 3,900 — nearly 8% below current levels.

The chorus of Wall Street strategists warning about a subdued end to the year has grown in recent weeks as stocks also face renewed geopolitical risks. The macroeconomic uncertainty as well as US bond yields nearing 5% have overshadowed the third-quarter reporting season, causing S&P 500 constituents to increasingly move in unison. 

JPMorgan Chase & Co. strategist Mislav Matejka sees further pressure on global stocks from an expected strengthening in the dollar, he wrote in a note dated Oct. 23. 

At RBC Capital Markets LLC, strategist Lori Calvasina also said the “outlook has become cloudier and we don’t think the pause in the S&P 500 rally is done yet.” Additionally, large-cap growth stocks are ripe for near-term declines as they’ve become “over owned and overvalued,” while balance sheet concerns, rising bond yields and economic gloom are hitting small-cap firms, she said. 

“The broader market, the growth trade and the small-cap trade are unlikely to find their footing again until the recent surge in bond yields comes to an end,” Calvasina wrote in a note.