Morgan Stanley’s Cross-Asset Strategy Team, lead by Gregory Peters, has a bearish note out, explaining why, in their view, the market has become particularly vulnerable.
Basically, markets in developed nations have run way too fast too far, given the economic underlying realities, a point that they demonstrate with this chart.
Photo: Morgan Stanley
The yellow line shows the outperformance of stocks relative to bonds. The blue line is leading indicators. Obviously yellow has shot up way ahead of the blue line.
Of course it’s possible that the Leading Indicators could shoot up (and note that the blue line is turning a tad higher), but regardless, this position has exposed stocks, both due to valuation reasons and tail risk issues owing to threats in both Europe and the US:
Equities have re-rated to levels where they appear increasingly vulnerable to bad news. We expect bad news: a significant shortfall in earnings versus current forecasts in both the US and Europe. Moreover, we think equity markets – and risk assets generally – are now too complacent about the risks around US fiscal policy and potential political backsliding in Europe.
Rising valuations have removed any buffer to earnings disappointment in developed markets. Our colleagues expect earnings to disappoint: Adam Parker expects 2013 earnings to be a little below those of 2012, while the consensus expects 12% growth. Graham Secker expects 2% growth in European EPS, versus 12.5% expected by consensus. The disappointing US Q3 reporting season fits with Adam’s view that forecasts need to come down.
Risk markets seem increasingly blasé about tail risks. This may be a central bank quantitative sedative at work, or investor short-termism. Either way, we see a significant risk – as high as one-in-three – that the US fiscal cliff ends badly enough to cause economic contraction. There seems a good chance Europe could loop toward another crisis phase in the repeating cycle of Crisis, Response, Improvement, Complacency. Despite these risks, until recently equities were rallying, spreads compressing, and volatility falling. Recent stumbles reflect an overdue recognition of risk, in our view.
There you have it: A stock market that got ahead of itself, earnings risk, and tail risk. Hence = selloff.