Morgan Stanley Throws In The Bearish Towel, Sees S&P At 2,300 On A 19x "Bull Case" PE Multiple
When Morgan Stanley's Adam Parker had a notable change in heart earlier in the year when he turned from a raging bull to a muted bear, it unleashed a series of odd letters to MS clients such as this one from April where "In Bizarre, Schizophrenic Note Morgan Stanley Compares Rally Chasers To "Cockroaches", followed by an angry noted aimed at "Fake Contrarians Who "Only Care About Price", culminating with a letter in July in which he feared becoming the "counter-indicating idiot."
Well, several months later, with the central banks refusing to allow his bearish narrative to manifest itself, this morning Parker flip-flopped again, and once more threw in the towel, this time reverting back to his old bullish ways, when overnight he released a note titled that "We Think the US Stock Market Is Going Higher", something he didn't think for most of 2016.
The justification of his racent change of heart was the same one used by so many other analysts who have zero fundamental legs to stand on: the Fed Model, or low bond yields resulting in high equity valuations. This is what he said:
We are raising our 12-month price targets for the S&P 500 – base case from 2200 to 2300, bear case from 1600 to 1800, and our bull case from 2400 to 2500. Our bull-bear skew is balanced, and our base case upside is now mid-single-digit, consistent with our continued optimistic outlook. While we have argued many times that we think forecasting the market-level price-to-earnings ratio is difficult, our best guess is that growth and interest rates ultimately matter in the long term. In fact, we have shown that historically, there was a relationship between real yields and price-to-earnings ratios for the markets Exhibit 1).
Parker summarizes his cognitive dissonance as follows:
In the past, extreme real yields, like where we are now at near 0%, were associated with lower price-to-earnings multiples because typically these were perceived as riskier regimes where the world was reliant on policymakers and their efficacy. So perhaps, the bubble we are all searching for is simply in the belief in the policymakers. On the other hand, a real yield of zero could be 17% on the 10-year yield and 17% on CPI, or 1.5% and 1.5%, and perhaps history isn’t a perfect guide, as different levels create different forward outlooks. Perhaps today's unconventional policy and heightened determination of policymakers mean that not all of history is relevant? Perhaps you can have a low-risk, extreme real yield environment? Admittedly, there is limited evidence of a low-risk, extreme real yield regime in the past, but, over the past few quarters we have been arguing that perhaps this historical relationship was broken this cycle
That said, Parker is now optimistic on the S&P for 4 main reasons:
- Bond yields are so low and seem risky – the old "relative to other asset classes" argument.
- 70% of the global equities that trade $100 million or more each day are in the US – the old liquidity argument.
- The US is the only major region with potentially positive EPS growth as a base case – the old fundamental argument.
- Investors aren’t positioned for big upside- whether you look at futures, options, prime brokerage data, surveys, or anecdotally from meetings, we don’t see excessive optimism among the client base – i.e., the old positioning argument.
What is amusing is that Parker still refuses to full let go of the bearish thesis, saying that "on classic metrics like price-forward earnings, the market is clearly more expensive than its historical median (Exhibit 2)."
However, in a nod to the momentum chasers he was mocking less than 6 months ago, Parker concedes that "this may not be an impediment. The US equity market offers a 2% dividend yield and more than a 2% net buyback, with we think about 3.5% per annum EPS growth for the next two years (Exhibit 3).
So how does Parker get to a 2,300 "base case" target as shown above: simple - not by raising earnings forecasts, which are set to decline for a 6th consecutive quarter, but by, drumroll, raising PE multiple expectations, which rise from a goalseeked 17.0 to 17.7x in the base case, and from 18x to 19x in the bull case forecast, resulting in a 2,500 S&P target.
This call option on EPS growth relative to low expectations today we think offers more attractive risk-reward than most other major asset classes. We left our base case EPS for the S&P500 unchanged, but raised our price-to-earnings assumption from 17x to 17.7x. For our bear case, we raised our EPS assumption from $100 to $106.9 two years out, viewing the flat EPS so far this year as a relative positive, implying that the acute drop-off factored into our prior bear case as increasingly unlikely. We are raising our bear case multiple from 16x to 16.8x. For the bull case, we are leaving our EPS essentially unchanged, moving the out year from $137.1 down to $136.5, but raising our bull case multiple from 18x to 19x, yielding our new 2500 bull case forecast.
The punchline, however, is Parker, "2020" forecast, where he still sees the S&P at 3,000 in just over four years:
The case for 2020: Two years ago, we partnered with our Chief US Economist Ellen Zentner to argue that we think this could be a long expansion, perhaps lasting until 2020, and implying that the US equity market will trade near 3000 by cycle end. We still believe this to be true, as most US consumer metrics appear directionally positive (housing, jobs, delinquencies, obligations, confidence, personal spending, etc.); corporate excess seems under control; and low growth is still the base case economic forecast. With few other attractive investment alternatives, we see the US equity market as the beneficiary of further appreciation.
We wonder if in a few months Parker will be raging at himself as the "fake contrarian" whose call led to the next move lower in stocks a la Gartman and Goldman, and dragging MS clients into the market back at its all time, or if this is that rare for 2016 case where a sellside strategist is actually correct.