Morgan Stanley
  • Wealth Management
  • Aug 19, 2019

Do Latest U.S. Stock Declines Signal a Return to Investor Realism?

The market has woken up to the risk of recession, which should be viewed as a healthy development.

Sharp stock market declines like we’ve seen this month can be challenging and create potential hardships for investors who have a short-term perspective. However, for investors with an intermediate to long-term outlook, stock market downdrafts (the S&P 500 is now down about 5% from its late-July high point) may be manageable.

It seems investors have now woken up to the risk of a recession, which we’ve been underscoring for a while. I’m actually more favorably inclined toward stocks vs. bonds now than I was in July. Bond yields are extremely low (bond prices move inversely to yields), leaving little income or price appreciation potential currently. Over the next 6 to 12 months, I think stocks are likely to outperform bonds.

Below are three reasons longer-term investors should consider adopting a contrarian view and think about recent declines as potentially a good thing:

  • Investor expectations are more realistic. Before the August slide, U.S. stocks seemed priced for perfection, which increased the potential for disappointment and volatility. Now investors recognize that the Federal Reserve may not be able to keep markets afloat and that trade tensions aren’t going away soon. Healthy markets are characterized by realism and often climb “a wall of worry.”

  • Earnings estimates will likely be recalibrated. With second-quarter earnings season concluding, data show that year-over-year profitability will be negative for a second consecutive quarter, constituting an “earnings recession.” Current 2020 forecasts of 12% profit growth seem unachievable. I expect corporate guidance on profits to turn more conservative. Wall Street analysts, in turn, will likely ratchet back their projections. This capitulation on the earnings outlook is a key reason why I favor stocks over the intermediate term.

  • Stock prices should become more reasonable. Valuation support, which has been lacking this year, now looks to be returning to U.S. stock markets.  With the yield on the 10-year Treasury down to just 1.6%, as of Friday, the equity risk premium (a measure of the risk-reward tradeoff for owning stocks over bonds) is well above the average levels over the past 40 years. I still see risks of recession rising and recommend a cautious stance, but I suggest investors watch for signals that U.S. stocks are nearing valuation support.  

To figure out if it may be time to put more money to work in stocks, watch for what’s known as a bear steepening of the yield curve. That’s when the Fed cuts short-term rates and then long-term rates start to rise, as investors begin to think we may be on the other side of the current slowdown. That could mark the beginning of a buying opportunity for stocks.