Investors have a new cause for heartburn, according to Morgan Stanley. They see a shift for the rest of 2018 from what they call a “rolling bear market,” in which nearly all sectors were taking turns being down by 20% or more from their 52-week highs, to a “choppy bear market,” characterized by increased volatility and largely sideways movement in stock prices. “The worst month for global equities since the last bear market in 2011-12 [is] now behind us,” Morgan Stanley says in its current Weekly Warm-Up report, but “liquidity [is] unlikely to improve, making it a potentially choppy ride for the rest of 2018.” Additionally, they see a negative trend in earnings revisions, as shown in the table below.

Red Flag: Earnings Revisions Breadth Is Plunging For These Sectors

Health Care
Real Estate

Source: Morgan Stanley

Significance For Investors

The typical measure of earnings revision breadth is to take the total number of upward revisions to analysts’ estimates, subtract the total number of downward revisions, and divide by the total number of revisions. This percentage also can be called the net earnings revision figure, as Yardeni Research prefers. From the beginning to the end of October, Morgan Stanley reports that this figure plummeted from 16.2% to 1.6% for the S&P 500 companies as a whole.

Looking at individual sectors, the worst performers in October per Morgan Stanley were industrials, dropping from 40.5% to -3.3%, and materials, which fell from 4.8% to -23.3%. That is, for both sectors, upward revisions of earnings estimates were exceeding downward revisions at the start of the month, but the reverse was true by the end of the month. Health care and real estate were the other two sectors with the biggest drops in earnings revisions during October, per Morgan Stanley.

“The worst month for global equities since the last bear market in 2011-12 [is] now behind us,” but “liquidity [is] unlikely to improve, making it a potentially choppy ride for the rest of 2018.” — Morgan Stanley

“Net income ‘beats’ are increasingly being driven by lower tax rate surprises,” the report observes. As a result, once 2018 is completely in the books, positive earnings surprises and upward earnings revisions driven by the corporate tax cuts that took effect this year should no longer emerge. “Tax cuts also have the effect of putting in a peak in growth and creating other stresses on an economy that was doing just fine before the tax cuts took effect,” says Morgan Stanley.

The report adds, “now the second-order effects of tax [cuts], which we have long argued were negative for margins, are starting to come to the surface.” One of those second-order effects (or unintended consequences) can be an accelerated pace of interest rate hikes by the Federal Reserve, to rein in inflationary pressures from an economy that they perceive as overheating.

About liquidity, Morgan Stanley warns: “the growth in global central bank balance sheets is set to decelerate and go negative by January. We think this will accentuate the choppiness and make it difficult to trade.” The Fed already has begun a gradual process of reducing its own massive balance sheet, worth over $4.1 trillion as of Oct. 31, per data from the Fed. Bonds held by the Fed are maturing without the proceeds being reinvested, thereby reducing liquidity as measured by the money supply, while also pushing interest rates upward. The European Central Bank (ECB) and the Bank of Japan (BOJ) are slowing their programs of bond purchases, called quantitative easing (QE), Morgan Stanley adds.

Looking Ahead

Driven by rising interest rates and peaking growth, Morgan Stanley notes that stock valuations, as measured by forward P/E ratios, declined significantly in the October sell-off. Meanwhile, value stocks beat growth stocks during the same period. “We think this signals a more important, longer lasting leadership change,” the report indicates. 


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