A decline inearnings growthduring the first quarter won’t come as a shock to Wall Street.
After all, analysts have already made the steepest cuts in years to earnings-per-share growth in the first quarter, and they may not be done downgrading yet.
However, whatMorgan Stanleyhas on its radar will come as a surprise: an earnings recession that lasts throughout 2019 and possibly beyond.
The firm’s view is primarily informed by the share of negative guidance companies are providing about the current quarter relative to positive guidance.
This measure, known as earnings revision breadth, is at its highest since 2016. That was the most recent year corporate America experienced a drought of profit growth, driven by the crash in oil prices and adollar spike.
“The earnings revision breadth over the past month has been even more negative than we expected leading us to think are [sic] earnings earnings recession trough in the US could be later than 1Q and deeper,” Mike Wilson, the chief US equity strategist at Morgan Stanley, said in a note to clients.
Wilson says not even theFederal Reserve’s pauseon raising interest rates would be sufficient to lift the market. The monster rally in January helped price in most of the support the Fed has to offer.
He’s skeptical of another development that has supported stocks of late: a successful resolution of the US-Chinatrade war. Even if the conflict fades away, the economic relationship between the world’s two richest countries has been scarred. This will likely result in higher costs for US companies, Wilson said.
He’s also not convinced that fiscal stimulus can save the day for corporate bottom lines, and expects the impact of the tax cuts to fade away.
All these factors put the broader indexes at risk of losses, in Wilson’s view. Earnings growth has historically been the biggest driver of stock prices, and so a decline in expectations would not bode well for the market.
“With the index stuck between a more dovish Fed and deteriorating earnings/growth, we advocate focusing on single stock risks and opportunities,” Wilson said.
He specifically recommends stocks that fulfill three criteria: (1) are historically undervalued compared to the rest of the market, (2) have better earnings revisions than the market, and (3) have earned worse returns since the peak.
Morgan Stanley’s screen of cheap stocks has returned nearly 11% since January 7, versus 7% for the S&P 500.