By Chris Matthews, MarketWatch
Mike Wilson, chief U.S. equity strategist at Morgan Stanley, has had impeccable timing of late.
In a July 29 note, as the S&P 500 index (S&P:SPX) sat near its record closing high of 3,025.86, Wilson argued that equity markets were stretched to their limits, and S&P would fail to break significantly above 3,000, unable to overcome an area that’s provided stiff resistance since last year. The S&P, Dow Jones Industrial Average (DOW:DJIA) and Nasdaq Composite Index (AMERICAN:COMP) have subsequently pulled back 5.5%, 3.5% and 5.2%, respectively with the S&P sitting at 2888.68, comfortably below 3,000.
“The market is preparing for a bad outcome,” Wilson told MarketWatch in an interview.
Wilson believes that his fellow strategists will increasingly come to admit this, as they realize that neither the Federal Reserve nor the White House can be the savior to markets that many investors hoped. He said that the “Fed Put” and the “Trump Put” are no longer relevant.
In real life, a put is an option that gives the holder the right but not the obligation to sell the underlying instrument at a set price by a certain time — a potentially valuable hedge if a bullish position goes south. The Fed put and the Trump put refer to the notion that either the central bank or the White House would be quick to implement policy actions aimed at arresting a steep market decline.
“The Fed put basically expired when they cut rates,” he said. “The hope of Fed cuts has been propping up the markets all year, but rate cuts aren’t good for the market if you’re going into recession.”
He explained that stock markets typically react well after the Fed pauses a rate cycle — as they have during the first seven months of the year. “But when the Fed starts cutting rates after a pause, the market doesn’t like it because things have deteriorated and a pause isn’t good enough.”
Wilson takes the inversion of various yield curves seriously, but said the most important to look at is the inversion of the yield on the 10-year U.S. Treasury Note (XTUP:BX:TMUBMUSD10Y) and the fed-funds rate. The 10-year yield fell below the fed-funds rate in May and the spread between the two has become increasingly negative since.
Federal Reserve Bank of St. Louis
“The market will remain volatile until the Fed gets ahead” of the trend of tumbling rates, he said, but that looks increasingly unlikely given the depth of the inversion.
Investors have also been hoping that the Trump administration would come to the market’s rescue, by spurring a rebound in global growth. However, “It’s pretty clear that the likelihood of a deal has gone down dramatically,” he said. “Investors were focused on the Fed, took their eye off the ball and didn’t notice that the trade rhetoric deteriorated greatly in July,” culminating in the president’s decision to impose yet another round of tariffs beginning Sept. 1, which triggered the market’s month-to-date selloff.
“In some ways you could argue that the trade put is gone too,” he said.
Market bulls say that Wilson is misguided, because he overlooks the strength of the U.S. consumer, as evidenced by retail sales growth surging in July, along with a rock-bottom unemployment rate.” The consumer is robust,” Wilson conceded. “But the problem is these numbers are lagging indicators — the consumer and the job market are always the last to go.”
He pointed to a weak reading of the University of Michigan’s consumer sentiment index, which fell 6.3 points in August relative to July and around 9 points compared with its cycle peak last year, along with data showing that average weekly hours worked has fallen to near two-year lows.
He said that a decline in hours worked is one of the better leading indicators of the health of the labor market, as companies are much quicker to cut hours than they are to fire workers.
Wilson said he thinks the market will continue to deteriorate in the coming weeks, with the S&P 500 falling to 2,700 or 2,650, and that this movement, along with a resulting widening of credit spreads could cause the Fed to act aggressively, potentially even cutting rates between scheduled meetings.
A close look at the markets should signal that investors see a slowdown as likely, given the relative popularity of interest-rate sensitive growth stocks and high-yielding, defensive sectors like utilities and real estate.
“Bond proxies are trading like internet stocks and high-growth, quality names are trading at record multiples,” he said. “It’s’ a bifurcated market, you have expensive growth and defense stocks and very cheap cyclicals.”