Morgan Stanley
  • Thoughts on the Market
  • Oct 19, 2020

Why the Correction May Not Be Over

With Mike Wilson
U.S. Equities Research for Investors

Uncertainty about fiscal stimulus, the U.S. election and the pandemic could mean the correction isn’t over. However, one thematic opportunity could present itself.

Each week, Mike Wilson offers his perspective on the forces shaping the markets and how to separate the signal from the noise. Listen to his most recent episode and check out those of his colleagues from across Morgan Stanley Research.

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Current Episode Transcript

Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 19th, at 11:30 a.m. in New York. So let's get after it.

With two weeks to go until the U.S. elections, the various outcomes remain uncertain. And this is weighing on investor psychology because there are so many things tied to the political outcome that will have meaningful impact on the real economy and various sectors. As such, financial markets have been trading in a wide range since August. For example, U.S. equity markets have not been able to make new highs in six weeks, the longest period since this new bull market began in March.

From a technical perspective, I've been closely watching a key resistance area for the S&P 500 since early September. And that comes in around 3550. Last week, the index failed to break through that level for the second time in two months. This technical failure is not the end of the bull market, but it does suggest to me that the correction that began in September probably is incomplete. In short, that means equity markets could experience another 10% correction back toward more formidable support levels. More specifically, the 200-day moving average, which comes in around 3125. Bottom line, from a technical perspective, I would be more inclined to add equity risk as we approach that level and more interested in fading equity markets at current prices.

From a valuation perspective, we see the same risk reward levels. At today's prices, the S&P 500 is trading at an equity risk premium of 380 basis points. That's fair, but a full level based on the current volatility of equity markets, which is slightly higher than average. However, with so much uncertainty surrounding the U.S. elections, Brexit, and the arriving second wave of COVID-19, we think the equity risk premium should be about 10% higher. In short, we like our 3100-3550 range on the S&P 500 as a good guide for risk taking, both from a technical and valuation perspective.

Beyond this simple trading view for the S&P 500, we think there's more important opportunity for investors to consider. As the recovery continues into next year, we believe investors should favor companies that can deliver higher earnings growth than what is already expected by the consensus. While many seem to favor companies that have been able to operate normally during this pandemic, that may not be the right strategy going forward. Essential businesses and services or digital transformation enablers have done great. But that just means expectations are already high. To the contrary, businesses and services that have not been able to operate normally may provide better investments at this time, primarily because expectations are low.

Investors need to be selective, of course, because many of these companies that aren't able to operate normally today may never recover. One thing that's certain about this pandemic is that many things we used to take for granted are likely to be different going forward. Secondarily, there are changes afoot that will require investment as the world demands better and safer ways of doing things. One such area is infrastructure where the world has under-invested for years, especially in the United States. With central banks willing and able to finance such a popular endeavor, we think this is one very attractive investment opportunity today.

This would favor companies in the industrial and materials sectors, particularly base metals like copper. We also think such spending will prove to be more inflationary than what the bond market is currently anticipating. That means higher long-term interest rates. While that's a headwind for fixed-income investments and stocks levered to lower interest rates, it's also an opportunity for stocks levered to higher rates, which includes those same infrastructure beneficiaries as well as financials. Bottom line, we recommend taking advantage of any near-term correction in the broader index to add to investments in these underappreciated areas of the market.

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