As U.S. equity markets casually melt up to all new highs with each passing day, Morgan Stanley Equity Strategist Michael Wilson, whose 2,550 year-end price target from back in August was just breached in a matter of months, says he’s getting somewhat concerned given Fed tightening, tax cut legislation that looks increasingly unlikely to pass, USD strengthening and extreme levels in pretty much every economic indicator which will make future improvement nearly impossible.
Given that, Wilson says he now sees “a greater risk for a correction than we have seen in a while…”
With the S&P 500 reaching the lower end of our short term price target (2550-75) we put out in August, we think there is a greater risk for a correction than we have seen in a while. If stocks follow the pattern they have been all year, actual earnings season will be a sell the news event and we could have a decent pull back or consolidation. Other things we think warrant concern include the Fed’s balance sheet reduction, uncertainty around Fed Chair nomination, negotiations on tax legislation, and the scope for a counter-trend US dollar rally.
Six weeks ago we went out on a limb with a shorter term target of 2550-75 for the S&P 500 to reach before 3Q earnings season as the market would realize consensus expectations were once again too low. Having breached that lower bound 9 days ago, we believe it is appropriate to respect the pattern we have been witnessing all year for stocks to rally into earnings season and then fade as the numbers actually get reported. Year to date, this has led to a max 3% drawdown which is not worth trying to play when there is still 15-20% upside. However, with less than 10% upside to our target, the risk reward isn’t as attractive to just ignore the potential for such a move. We also think it could be bigger than 3% this time given other factors at work. Specifically, we must acknowledge:
- the Fed is reducing its balance sheet this month for the first time since QE began,
- tax cut legislation is trickier than tax cut promises, the negotiations begin this month
- we are going to get the next Fed Chair nomination later this month which could disrupt financial conditions
- The US Dollar appears to be in the midst of a countertrend rally, and
- given the extremes in leading economic indicators like the purchasing manager surveys, the chance of a peak rate of change looks more likely than not.
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