•  Morgan Stanley’s Michael Wilson, chief US equity strategist, sees further downward revisions in earnings for 2019

•  Jurrien Timmer, Fidelity Director of Global Macro, is more bullish based on looking at the context for the earnings revisions

•  We find the weight of the arguments in favor of glass half full and continue to hold a neutral weighting of stocks to bonds in our model portfolios

CNBC published an article today discussing Morgan Stanley’s view on US equity markets. In a nutshell, Michael Wilson argued that 2019 earnings revisions have come down 4-5% since peak earning in Q3 2018. He expects we will see further downward revisions of about 4-5%. As a result of this viewpoint, Morgan Stanley is shifting it’s equity focus from cyclical stocks to more defensive positions.

Meanwhile, Jurrien Timmer penned an interesting piece entitled, ‘Context is everything’. This piece takes a more optimistic view of the current state.  He discusses the 20% decline we had in Q4 and the change in circumstances we now currently see.

Timmer argues that the 20% drawdown was driven mainly by the slowing earnings growth combined with monetary tightening by the US Federal Reserve. He argues this was compounded by the forced liquidation of crowed momentum trades as well as a lack of market liquidity, ‘especially heading into the year-end’.

Going forward he proposes that we need to understand the four drivers to the market and their current state: earnings, liquidity, valuations and sentiment.

Earnings

Timmer argues that earnings have decelerated significantly from +24% in 2018 to roughly 6% for 2019. This is close to the 5% assumption that Dr Ed Yardeni forecasts for 2018. Currently the S&P 500 is showing a bottoms up forecast of 12% for 2019. However, he then argues that the three other driving forces tend to offset this decline in earnings.

Valuation

Timmer argues 2018 was the year of ‘valuation reset’. Forward PEs peaked at 19.5x and by the end of January had fallen to 13.7x. One of the key measures of valuation we use is the Real Earning Yield. Given 10Y treasury rates of 2.65%, the Real Earnings Yield is just above 2%. At this point, based on the Real Earnings Yield, markets are not significantly over-valued or under-valued.

Sentiment

Timmer says sentiment ‘did a complete round-trip’. He backs this claim up by discussing flow of funds data that showed investors pouring money into stocks early in 2018, only to reverse course late in the year. One counter point to Timmer’s argument is that Q4 CEO investor sentiment took a large downturn. Consumer sentiment is down somewhat, but hasn’t set any red flags yet.

Liquidity

The strongest point made by Timmer is that the Fed has pivoted to a very dovish stance compared with its position prior to Q4 2018. As of January, the Fed appears to be in a wait and see mode in contrast to the forecasted 3-4 rate hikes previously anticipated. He concludes by stating, ‘Against a backdrop of a slowing but still growing US economy and amid very few if any, signs of a recession, the above factors all suggest that the 20% drawdown in stock prices and the related 30% de-rating in the P/E ratio was just a mini-bear and not the start of a much deeper retreat.’

Conclusion

On balance, it appears likely that Morgan Stanley’s view of continued deceleration in earnings for 2019 will occur. That said, if earnings come in at 5% growth and interest rates and inflation remain in check, we think the arguments Timmer is making are sound. Context is everything.

With valuations essentially neutral, we keep our model portfolios in balance relative to their stock-bond allocation.