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Two Key Points about a U.S. Recovery

With Mike Wilson U.S. Equities Research for Investors

Although a worrying trend in new U.S. COVID-19 cases has some investors understandably bearish, they may be overlooking two key points about earnings and sentiment.

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, June 29, at 8:30am in New York. So let's get after it.

2020 has been an unusual year that started with record low unemployment and equity markets making new all time highs just about every day. In fact, in January and February, it was hard to find anyone who was negative on the economy, or the stock market. In March, that all changed with the novel coronavirus turning into a full fledged global pandemic. The subsequent lockdown of the U.S. economy to fight the disease led to the most sudden and severe recession in history.

What followed next was unprecedented monetary and fiscal stimulus, which means we are likely to experience one of the sharpest recoveries on record, too. Stock markets around the world seem to agree, with most major averages trading extremely well. Such a rally in stock prices has many people nervous that markets are disconnected from the fundamentals and do not reflect the still looming risks. But equity markets move well ahead of the economy and are often the best leading indicator. In short, we think the V-shape recovery in markets is foreshadowing what will be a V-shape recovery in the economy and earnings.

In fact, one thing investors may be overlooking is how fast earnings often rebound after a recession. The main feature of any recession is that unemployment rises sharply. In the current case, unemployment went from a record low 3.5% to almost 15% in just two months. Typically, it takes 1-2 years for the unemployment rate to reach its cycle peak. Furthermore, the increase in unemployment was twice as large as usual, leaving cost structures even more lean than normal coming out of a recession. As a result, we think operating leverage could be explosive as the economy recovers. From an investment perspective, this means earnings will return to prior highs much faster than most analysts are forecasting and stocks can continue to move higher, especially the more economically sensitive ones, including small caps.

Another unusual feature of this recession is how bearish the average investor remains despite the record rally. From our analysis of investor positioning and conversations with clients, we view the institutional investor sentiment as neutral at best while retail investors remain outright bearish. We think this is a function of the fact that we are still in the midst of a health crisis which is disproportionately weighing on individual investors. This presents a wall of worry that will eventually be scaled when the virus is eradicated, either by herd immunity or a vaccine. Therefore, weakness in the stock market, like last week, should be used as an opportunity to add to equity positions.

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