Investors should be ready for a "choppy" third quarter as uncertainty over corporate earnings, Fed policy and the U.S. election create the perfect storm for a market correction.
In a Monday interview, Morgan Stanley's Chief Investment Officer Mike Wilson said the market should brace itself for a 10% to 15% correction between now and November.
This means that the S&P 500 could be close to its 2024 ceiling. The index hit its historical ceiling on Friday after a positive jobs report lit up investor enthusiasm.
What Needs To Happen For Small-Cap Businesses To Thrive?
Companies with bad earnings reports "are going to get punished," Wilson told Bloomberg Television.
These include most of the S&P 500 companies that are not in the top 50.
This is what's been happening this year for most companies, outside of the small group of large-caps that actually have positive earnings. Currently, only 17% of S&P 500 companies actually beat the index in the past month.
The S&P 500 is closely monitored through ETFs such as the SPDR S&P 500 ETF Trust SPY, Vanguard S&P 500 ETF VOO, and iShares Core S&P 500 ETF IVV, providing various avenues for investment in its comprehensive performance.
"The average company does not have good earnings results," Wilson said.
Although the market has seen an expansion in corporate earnings this year, this growth is coming from "30 or 40 companies."
Fertile conditions for growth for smaller companies tend to come when the country is coming out of a recession. This is because when a new cycle starts, low interest rates open up access to capital and companies gain operating leverage.
This, unfortunately, is not where we are today.
For smaller businesses to thrive in the current landscape, the Fed would need to cut interest rates "meaningfully" for the cost of capital to come down.
The labor market would need to loosen, meaning that the unemployment rate should go up for businesses to be able to hire workers at "more reasonable" prices within their balance sheets, Wilson said.
This would lead to a scenario where small-cap companies can recover pricing power and are able to improve their earnings.
Yet for the Fed, this is a challenge. The agency needs to bring down interest rates at a rate that helps tackle inflation, but also give enough time for companies to recover since, according to Wilson, lower inflation is also hurting smaller companies if they don't have access to capital.
"One thing that gets overlooked is that companies are losing pricing power now. So while we're all rooting for lower inflation, weaker inflation is not great for earnings," Wilson said.
Where Is The 10% Correction Coming From?
Wilson says that investors currently have a lot more exposure to high-multiple stocks than they are aware.
High-multiple stocks are those whose market value is many multiples above their price to earnings ratio, meaning that they're overvalued.
“If you have an event that's unpredictable, then you can have a real reset on valuations of 10% or 15%. I think the chance of a 10% correction is highly likely sometime between now and the election.”
This is because the market is still waiting to find out whether Joe Biden or Donald Trump will head the government next year, which will have a serious impact on tariffs for imported goods, as well as immigration policy and other key policy issues.
But uncertainty will likely prevail for reasons other than the election itself, says Wilson.
Expectation on a Fed decision to cut rates, which are independent of who wins the election, as well as uncertainty over company earnings leads to a third quarter where the market can take a hit. This could be true if the uncertainty moves investors to cash in on higher valuations before the prices of stocks go down.
The upside, says the pundit, is that lower stock prices will bring in opportunities to buy, making for more "exciting" valuations.
Read Next:
Shutterstock image.
© 2024 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.
Comments
Trade confidently with insights and alerts from analyst ratings, free reports and breaking news that affects the stocks you care about.
