Morgan Stanley’s chief equity strategist Adam Parker is one of the most interesting voices on Wall Street.
Recall that Parker admitted in his outlook for 2016 that he really had no idea what was going to happen to the stock market this year.
Moreover, Parker argued that this is not an affliction unique to him: no one really knows where the market will go next.
And on Tuesday, Parker reiterated that call.
“Trying to figure out where the market is going is like taking something we don’t know how to forecast (the price-to-earnings ratio for the market) and multiplying it by something we aren’t very good at forecasting (the earnings for the market),” Parker writes.
“Sadly, we arrive at this knowing we spend much more time thinking about it than most other people in the world.”
And so basically Parker knows that no matter what he and his team do they will never be able to accurately the forecast the stock market’s two main inputs — valuation and earnings — and will therefore never correctly predict where the market goes next.
(We’d imagine that Parker would concede that were the S&P 500 to trade exactly to his forecasted level in a year’s time it would be for reasons other than what he’d cited.)
In Tuesday’s note, Parker says that one of the most common questions clients ask is about the S&P 500’s price-to-earnings multiple, which you can roughly think of as how many dollars investors have to pay for $1 of earnings. Right now, the S&P is trading at a P/E of about 20, somewhat above its long-term average of closer to 15.5.
Here’s Parker (emphasis ours):
We are constantly asked about the price-to-earnings (P/E) ratio for the market. We have always written that we don’t think anyone can forecast the market level P/E ratio in time frames less than a few years. However, in volatile times, we can try to contextualize where we are and what’s changed.
Our best guess is that 50% of an average US recession is already priced into the S&P 500… Given the market peaked in May of 2015 roughly 13% above today’s level, and 1600 is about 15% below where we are currently trading, we think it is reasonable to say about half of a recession is embedded in today’s market level. Likely, more than that is embedded in certain industries and stocks. One question we get a lot is “what’s the right market multiple?” Of course the answer is “we don’t know.” We don’t think there are any data points that empirically have predictive value in forecasting the market multiple.
Now, the numerator of the P/E multiple is, in Parker’s view, easier to forecast. Corporate earnings tend to be less volatile than the price than an investor is willing to pay for a future claim on those earnings.
But at least in the most recent cycle, Parker and his team underestimated earnings early in the cycle and missed the way the oil crash would impact results across the spectrum of S&P 500 industries (the energy hit was known but the consumer benefit was overestimated).
And so as Parker noted above, take these two guesses — P/E and just E — and you’re left with a whole bunch of “who knows?”.
But because no note is complete without a market call (however flawed it may be), here’s Parker:
Good is good and bad is bad — that’s our mantra for 2016. The market is selling off for a laundry list of reasons: narrow breadth, China currency depreciation, tighter financial conditions, a Fed that hasn’t spoken incrementally dovishly, and a weak oil market. In essence, a view that future economic data are about to deteriorate. But, we don’t think the probability of a recession and a material earnings correction is as high as what is priced in. This is just a judgment call based on the health of the US consumer, the modest fiscal stimulus we expect in 2016 (as opposed to drag), and the importance of the consumer relative to the manufacturing sector, where trends are clearly inferior. We are more bullish now than we were a few weeks ago, because the market is down 8% in just 10 trading days, and our view of earnings is not similarly, or really at all, impaired.
So buy stocks, I guess.