Stocks could be due for a correction of up to 20% ‘by fire or ice’: Morgan Stanley strategist

Morgan Stanley’s Chief Investment Officer Mike Wilson says investors should always be positioned for a market correction of 10%, but warned that investors may not be ready for a harsher correction that could be coming soon.

“You should always be expecting a 10% correction. If you’re investing in equities, you should be prepared for that at any time,” Wilson told Yahoo Finance on Friday. “A 20% correction, which is really more disruptive, where people might want to try and position for, the catalyst for that is going to be once again an ice scenario.”

Wilson’s “ice scenario” envisions a sharp reversal of the post-lockdown “overconsumption binge,” which could slow the stronger earnings and operating leverage seen in S&P 500 companies as of late.

“It would be natural that the mid-cycle transition ends up being worse than normal,” Wilson said.

Wilson added that historically, price-to-earnings ratios for the S&P 500 tend to fall by about 20% in a mid-cycle transition, pointing to 1994, 2004, and 2011 as examples. P/E ratios compare a company’s share price against its earnings per share, and have been elevated through the pandemic recovery.

In an August 30 note, Morgan Stanley Research noted that forward 12-month price-to-earnings ratios for the S&P 500 had already fallen by 5% so far this year. Source: Bloomberg, Morgan Stanley Research

Wilson says the correction may have already begun, with P/E ratios on the S&P 500 falling by about 5% so far this year. Characteristics of previous mid-cycle adjustments, such as the outperformance of large caps as autos and consumer discretionary lag, are already happening.

“We think it has simply been deferred as excess liquidity and retail and international inflows have kept the major U.S. indices elevated,” Morgan Stanley noted in research published Aug. 30.

The equity strategist said a further slowdown in P/E multiples could come “by fire or ice.” In the “fire” scenario, a booming economy with sustained inflation pushes the Federal Reserve to raise interest rates and take steam out of the stock market.

The “ice” scenario is the overconsumption binge hypothesis, which Wilson said is the one his team is leaning towards.

“The bottom line for us…is the risk reward is not particularly great at the index level from here, no matter what the outcome is. That’s why we don’t have any upside to the S&P for the rest of the year,” Wilson said.

Wilson’s team recommended financials and consumer services as defensive plays to a possible correction.

Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

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