Morgan Stanley: Welcome to the ‘death zone’

With the calendar quiet and seemingly half the City on the ski slopes, how could FT Alphaville not be intrigued by analysis that mentions a “death zone”?

Morgan Stanley has seized upon the week’s alpine overtones with some mountain-themed equity strategy, with some interesting takeaways on the dash to trash we’ve seen so far in 2023.

Michael Wilson and pals have their eyes on equity risk premium — they warn that this gauge of potential upside has plunged to its lowest levels in the post-financial-crisis era:

With the Equity Risk Premium at its lowest level since 2007, the risk-reward for stocks is extremely poor, particularly with a Fed that is likely far from done, and earnings expectations that are 10-20% too high. It’s time to head back to base camp before the next guide down in earnings.

They reckon:

— Strong recent data has “taken a Fed pause/pivot completely off the table”
— Despite bearish vibes, “both active institutional and retail investors are more bullish than they have been in over a year”
— Earnings per share growth and sales growth have become disconnected, which means an EPS slowdown looms

The recent equity rally has been fuelled by a surprising abundance of liquidity, even as the Federal Reserve moves to tighten monetary policy. Rather than fighting (or not fighting) the Fed, traders should take a more global view, says Morgan Stanley:

[We] think the primary reason for why stocks have been rallying since October has to do with the plentiful global liquidity that has been provided from the PBoC, BOJ and weaker USD rather than any dovish change from the Fed . . . 

[We] believe the “offset” from the PBoC, BOJ and weaker dollar has more than cancelled out the Fed’s effort to tighten financial conditions which have loosened considerably from October levels.

They continue:

The inconsistency of the price action between stocks and bonds is a good example of false readings during a time when liquidity may be clouding the fundamental picture. Perhaps the strongest evidence that the current environment is one of the riskiest we have witnessed since this bear market began comes from the latest reading of our Equity Risk Premium . . . 

With the ERP reaching just 155bps last week, we believe the risks are extreme now and nearly impossible to justify with any narrative one wants to conjure up.

Here’s that ERP “death zone” in all its glory. (Shouldn’t the peaks be more dangerous in a mountain analogy? Winter sports enthusiasts please comment below.)

The strategists say the recent rally is a dangerous illusion, with the risk-reward on the S&P 500 now “very poor”:

This is pure FOMO at its best, in our view, and we find all the hoopla and excitement about the YTD rally to be misplaced. The reality is that the S&P 500 is flat over the past 11 weeks and exactly in line with where we took off our tactical bullish call on December 5th at 4,071. The main difference is that stocks are now significantly more expensive with the ERP at 168bps versus 216bps back then.

They conclude, ominously:

Bottom line, investors are not bearish any longer, and this is just another reason to be wary of the set-up going into what is likely to be another weak earnings season.

Stay safe out there, skiers.