Morgan Stanley: Året slutter som nu

Bottom line: While we aren’t suggesting investors go on a buying spree, markets are now trading slightly below our downside case on the S&P 500; given the accelerated move lower, we believe that longer-term investors might start to consider adding to equity risk.

The end of the cyclical bull market was likely accentuated by liquidity-induced froth, as the Fed expanded its balance sheet last year. This liquidity, alongside economic green shoots and low volatility, invited more risk-taking and leverage from most corners of the market.

The past few weeks have helped reduce this leverage, but the obvious signs of funding stress that began in the third quarter, 2019, always made investing based on another round of quantitative easing a much riskier proposition for market participants.

Within that context, the velocity of the recent market drop is understandable, even if it came sooner than expected, due to the shocks from the outbreak and oil price war.

So what’s the downside? We still think that 2750 may be a reasonable year-end bear case for the S&P. Should the U.S. dip into recession, it would likely be short-lived and policy responses could help stabilize and even accelerate growth from a trough in the second and third quarters. To put it more simply, for the S&P to end the year at around 2750 would imply lingering issues beyond a garden-variety recession that currently seem unlikely.

It’s also worth noting that liquidity-driven overshoots can work in both directions. We overshot our bull case to start the year, amid abundant liquidity and absent near-term risks. Now, we’re overshooting again, but on the downside, given a lack of buyer appetite to make a market and extreme uncertainty around what this outbreak really means.

We’ve been watching 2550-2600 as a level for the S&P in an overshoot—a level the S&P has already traded below. To the extent that volatility and uncertainty limit buyer appetite, further investor reductions in gross exposure could push the liquidity-driven overshoot further than we expected. However, for investors with a 6-12-month horizon, the 2550-2600 level may offer an attractive risk-reward buying opportunity. We are also encouraged by the fact that 10-year Treasury yields are not making new lows which can signal an investor flight from stocks.

Given the accelerated market move lower, we also wouldn’t be surprised by earlier-than-expected exit rotations. By the time jobless claims spike, or the National Bureau of Economic Research officially declares that the recession has started, it will be too late to make the rotations that outperform off the market’s trough.

We aren’t suggesting that investors begin to add positions to early rebounding sectors, such as Discretionary, but that moment may be closer than some investors expect. Equity (and bond) markets have been discounting this environment for some time, which leads us to believe that we are now at a very good entry point for many stocks, including several of the major indices, such as the S&P 500.