Market Rally Or 'Speculative Frenzy'? Why Morgan Stanley Says 'Payback' Is Coming, S&P 500 Could Crash To 3,000

Morgan Stanley MS analyst Michael Wilson sees the risk-reward opportunity in the markets at current levels as severely skewed to the downside, and he's telling investors to take shelter before the market gets bombarded with disappointment.

What To Know: In a new note to clients Tuesday morning, Wilson issued a stark warning about the challenges facing U.S. equities and the likely outcome of what's ahead. 

"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," the Morgan Stanley analyst said.

Although recent data has kept a potential soft landing in the economy on the table, Wilson believes it has also removed a potential Fed pause or pivot from the realm of possibilities.

Following two consecutive downshifts from the central bank, the Fed is all but guaranteed to continue raising rates at its next meeting in March. 

"As a result, rates are higher across the curve, leaving stocks more expensive than at any time since 2007," Wilson said.

Further adding to Wilson's bearish take, the Morgan Stanley analyst believes earnings expectations are elevated. An overshoot of 10% to 20% from analysts has set the market up for massive disappointment.

Furthermore, both institutional and retail investors are more bullish than they have been in more than a year, Wilson said, adding that retail investors are nearly as bullish as they were when the SPDR S&P 500 SPY peaked in January 2022. 

"We also find it strange there is so much excitement about the YTD rally when in reality the S&P 500 is flat over the past 11 weeks and at the same level," the analyst said. 

Tuesday morning on CNBC's "Squawk Box," Wilson called the rally more of a "speculative frenzy," noting that it's largely based on hopes for a Fed pause or pivot that isn't coming anytime soon. 

See Also: Nervous Consumers Make for Nervous Market as Walmart, Home Depot Share Disappointing Outlooks

"The Fed doesn't want to give any chance to inflation rearing its head again, so we think there's at least two more hikes, maybe three, going into June. That got priced into the bond market over the last 30 days, but stocks seem to have ignored it," he said. 

The chances for a 0.5% hike continue to climb, most recently up to 24% at the Fed's March meeting, according to CME Group data. On the other hand, if the Fed opts for a 0.25% hike at its next meeting, the bond market is currently projecting a 73.8% chance of a subsequent 0.25% hike in May and a 57.2% chance of another 0.25% hike in June.

Wilson told CNBC that he expects the S&P 500 to trade down to somewhere between 3,000 and 3,300 in the next three to six months. 

"We overshot to the upside both on earnings and valuation, so it's just a bit of a payback on a cycle that went well beyond where it should have," the Morgan Stanley analyst said.

SPY Price Action: The SPY is diving in the wake of Wilson's comments. It was last down 1.92% at $399.43, according to Benzinga Pro.

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