According to Morgan Stanley’s Michael Wilson, a surprisingly good start to the US stock market in 2023 is likely to fade this week as the Federal Reserve prepares to announce its eighth straight rate hike after at the end of the policy meeting.
“We think recent price action is more reflective of seasonal january effect and short-term offset after a tough December ended and a brutal year,” wrote a group of strategists led by Wilson, director of equity strategy at Morgan Stanley. “The reality is that earnings are even worse than scary based on the data, especially when it comes to margins.”
January started off on a high note for stock market investors, with the three major equity indexes on track to post strong monthly gains. As of Friday, S&P 500
SPX,
rose 4.6% in the first four weeks of January, while the Dow Jones Industrial Average
DIA,
1.7% increase. Tech stocks have the best January in decadeswith Nasdaq Composite
CALCULATOR,
rose 8.9% in the month to Monday, its best January performance since posting a 12.2% gain in 2001, according to Dow Jones Market Data.
However, Wilson and his team were surprised by the magnitude of the recent move. It’s “just another bear market trap” and “all the good news is priced in now,” meaning “reality is likely to return at the end of the month and the Fed’s determination to tame inflation,” they wrote in a note Monday.
See: What stock market investors need to know about the ‘Trifecta January indicator’
The “January effect” is a seasonal trend for small-cap stocks that rebounded in the month after collecting tax losses in December on generally illiquid stocks. In theory, investors could use that money to buy back new positions in January, which could contribute to the monthly rally.
Other possible explanations include “window decoration,” an activity undertaken by institutional investors to buy more shares of the best performing stocks at year-end in order to improve their appearance. fund performance before presenting it to shareholders.
Another factor is investor sentiment, as investors tend to be more optimistic about the future as a new year begins.
Morgan Stanley strategists warned earlier this year that a recession shock in 2023 could send stocks down another 22%and they expect the large-cap index to end the year at 3,900. The S&P 500 closed down 52 points, or 1.3%, at 4,018 on Monday.
Furthermore, Wilson argues that investors seem to have forgotten the basic “Don’t fight the Fed” rule. He said the upcoming FOMC meeting, which ends on Wednesday, will serve as a reminder.
The central bank is expected to raise its target federal funds rate by 25 basis points, to a range of 4.5% to 4.75%. Traders now place a 98% probability on that size up, according to the report CME . FedWatch Tool.
So far, however, the Fed has shown no sign of being ready to put the brakes on and actually switch to a more dovish stance. That, coupled with the fact of the worst earnings recession since 2008, “is again, in our view, undervalued,” Wilson said.
See: The Fed and the stock market are in conflict this week. What is at stake.
Morgan Stanley’s 2023 base-case forecast for the S&P 500’s earnings per share (EPS) is $195, while their downside-case forecast is $180. EPS refers to net income divided by the number of shares outstanding and can show how much money a company earns per share.
Wilson and his team say they are now leaning more towards a downside case of $180 based on a deterioration in the range. “We think it’s important to note that typically when futures earnings growth is negative, the Fed is actually cutting rates. That’s not the case this time around, (it’s) an additional headwind for equities.”
