Morgan Stanley
  • Research
  • Jan 24, 2023

The Bear Market May Not Be Over Yet

The final stages of a bear market tend to be the trickiest. Investors should stay focused on fundamentals and ignore false signals and misleading reflections in this bear market hall of mirrors.

Coming into 2023, most investors seemed to have the same outlook for the year: a tough first half for U.S. equities, followed by a strong finish, with a U.S. recession beginning sooner rather than later. Recently, however, the consensus view has shifted sharply. More investors are starting to entertain the idea of a soft landing for the economy, while many others have pushed the timing of a recession out to the second half of the year.

There are valid reasons for investors to modify their views, including China's reopening and declining natural gas prices in Europe. But the biggest driver has been a U.S. market rally – and here’s where investors need to be careful. The rally this year has been led by low-quality and heavily shorted stocks. Moreover, it’s been marked by a strong move in cyclical stocks relative to defensive stocks, which is convincing investors that they are missing the bottom and must reposition.

In fact, bear markets have a way of fooling everyone before they're done. The final stages tend to be the trickiest, and we have been on high alert for such head fakes, such as the rally from October to December (which we anticipated). Times like these are when investors lose confidence and start to question their processes as price action and crosscurrents in the data create a hall of mirrors.

This is precisely the time to examine fundamentals and ignore the noise. We’re not biting on this recent rally because our research is so convincingly bearish on earnings. Importantly, our call is not predicated on the timing of an economic recession or even whether one occurs this year. Rather, our research shows further erosion in earnings, with the gap between our model and the forward estimates as wide as it's ever been. The last two times our model was this far below the consensus, in December 2001 and August 2008, the S&P 500 fell 34% and 49% respectively.

We think the earnings recession is imminent, and we find the shift in investor tone supportive of our call for new lows in the S&P 500. In our view, the bear market will not end until later this quarter or early in the second quarter. 

To be more precise, our forecasts are predicated on companies seeing disappointing margins, with costs growing faster than sales. Recessions in particular lead to significant negative operating leverage for that very reason; sales fall off quickly and unexpectedly, while costs remain sticky in the short term. That’s exactly what is happening in many industries already.

After a very challenging 2022, many investors are still bearish fundamentally but question whether negative fundamentals have already been priced into stocks. Our view has not changed, as we expect U.S. earnings to disappoint both consensus expectations and current valuations.

In fact, we see the change in sentiment and positioning over the past few weeks as a necessary condition for the last stage of this bear market to play out. We advise investors to stay focused on fundamentals and ignore the false signals and misleading reflections in this bear market hall of mirrors.