‘You should always be expecting a 10% correction in the market:’ Mike Wilson

Chief Investment Officer and Chief U.S. Equity Strategist at Morgan Stanley Mike Wilson joins Yahoo Finance to discuss the trajectory he sees the market taking in the remainder of the year, the rally going on with FAANG stocks, and the possible policies the Fed could enact in the market.

Video transcript

BRIAN SOZZI: The market is off to a little bit of a shaky start in September for an array of reasons. Will the Fed taper its bond purchase early? Is the Delta variant a greater risk than many people think? Our next guest says these concerns are very valid, and they may lead to a near-term market correction. Mike Wilson is chief investment officer and chief equity strategist at Morgan Stanley. Mike, good to see you here on this Friday morning.

Really interesting note out from you and your team laying the groundwork or making the case for a near-term correction, 10% correction either by fire or ice. So now that we're almost midway through September, which path do you think we're going to head down?

MIKE WILSON: Yeah. Thanks for having me on. I mean, we're an interesting junction, I would say. Interestingly, this year has played out almost to script exactly at the stock and sector level, meaning kind of this mid-cycle transition narrative we laid out in March has really played out, meaning lower-quality parts of the market have underperformed, and the higher-quality parts of the market-- and I mean globally-- have really outperformed.

And that's really kept the indices, the major indices like the S&P 500 and NASDAQ, elevated. While lower-quality indices, say, like the Russell or the transportation index, some of the early cycle stocks, they have really underperformed. And that fits very neatly with this time of economic expansion.

What's missing is the full final derating that we typically get in that transitional period from peak rate of change on growth to something more modest. And what you usually get is about a 20% derating in the S&P 500 PE multiple. We've gotten about a 5% derating so far.

So we see no reason why that won't complete itself. Very similar, by the way, to other mid-cycle transition years like '94, '04, 2011, and then, of course, now.

So that's what we're looking at. We're looking at, OK, well, how is that last part going to manifest itself? Will it be by fire, meaning things overheat, the Fed tapers, rates go up, and then multiples come down? Or will it be something a little bit more negative, I think, which is the kind of correction by ice, or that the slowdown that we're seeing right now ends up being more persistent, that we don't really see much of a snap-back in the fourth quarter as Delta fades, that this is more about payback in demand from last year's overconsumption binge?

And that's the part we're leaning towards. So that's a long answer to your question. But we're leaning towards that sort of continued slowdown being a little bit worse. And the reason why is not because of the virus and Delta but because we just overshot on the upside so much.

So the nature of this recovery has been very acute. One of the reasons we were overly bullish last year is because we said we were going to have a period of over-earning and operating leverage is going to be surprisingly good. And we got that. In fact, it was even better than we expected. So it would be natural that the mid-cycle transition ends up being worse than normal.

JULIE HYMAN: Hey, Mike. It's Julie here. You mentioned the fourth quarter is really when it should start to crystallize or be more clear. How do you sort of then time the strategy to coincide with that? And what are some of the key data points you're going to be looking for to confirm whether you're correct on the ice part of the equation?

MIKE WILSON: Yeah, I mean, that's always the trick is timing. And it's very, very difficult sometimes to time these things. And once again, we got the sector style rotations perfectly timed. We have not gotten the index timed very well. We thought this would have happened maybe a couple of months ago. And it's persisted to move up.

And I think part of that is due to money flows. So as everybody knows, the retail investor has been pretty aggressively putting money into the market. Corporates have also been active because they over-earned in the first half of the year, so they've been buying back stock. And that's really allowed the index to stay somewhat inflated.

We've also seen inflows from overseas, as China's stock market has had issues. Some of the money that was over there has moved into the US as sort of a safe haven. And so that's been the tricky part.

So we'll be watching those money flows. The supply of issuance is going to be picking up in September, as it typically does. Corporate buybacks will slow down into the quiet period, as they typically do. So that's one thing.

The other areas we're really watching is consumer confidence. As you know, that's really peeled back. We think that's indicative of a consumer that's maybe tired. And so we really want to watch some of the consumer-leading indicators, whether it's retail sales or other forms of spending consumption.

And then the last one is probably the PMIs. So the PMIs have peaked. We know that. The question is, how far do they come back in as some of the supply chain disruptions get resolved? We think the PMIs should come in harder than people are expecting. And so that's what we'll be watching as well.

BRIAN CHEUNG: Hey, Mike. It's the other Brian here. When you talk about timing, how does the Fed factor into that? And I know that part of your fire thesis might be the Fed tightening policy. When I hear tighten, I'm kind of discerning rate increases down the line as opposed to tapering, which would still largely be accommodative.

But there are some concerns that it's the taper announcement, whether that comes in September, more likely in November, that could trigger some sort of market reaction. Do you think that would be the case as we look towards those short-term risks as far as headlines go from the Fed?

MIKE WILSON: Yeah, that would definitely fit into the fire scenario, meaning that right now, I think the reason why rates haven't moved to the back end, even though the Fed has been pretty explicit about they're going to begin tapering later this year, the back end has been pretty sticky on the downside partly because we think the market's been so prepared for this by the Fed, number one. And there's still other sources of liquidity around the world that are helping to offset whatever the Fed is going to do on tapering.

But then secondarily, I think the bond market is also kind of sniffing out what I just talked about, that the growth deceleration could end up being worse or more persistent than what people are kind of expecting. So all this is going to manifest itself into the fourth quarter. And all these questions are going to be answered.

The bottom line for us-- we think it's the most important thing is that the risk-reward is not particularly great at the index level from here, no matter what the outcome is. So that's why we don't have any upside to the S&P 500 for the rest of this year. In fact, we have downside to our targets.

And we're trying to make money in different ways and trying to find the stocks that will work, the relative value trades that we think are still available.

BRIAN SOZZI: Mike, I've been surprised by the rally, let's say over the past month, in some of these high-quality stocks. Let's call attention to the FANG stocks. Some of them have really ripped higher, despite fears of a Fed taper. Can those rallies continue, even though it does look like the Fed will taper later this year or, at the latest, start doing this early 2022?

MIKE WILSON: Yeah, I mean, the high-quality large cap growth stocks, I mean, that is usually what holds up the best in the mid-cycle transition. So that's not surprising. That was part of our call back in March. They have probably gone a little bit further than I would have gathered because of some of those inflows from whether it's retail, corporates. Don't forget, the biggest corporate buyers are the large cap growth companies. And then of course, the flows from China and global investors.

And look, I think tapering is one part of the equation and, I think, should ultimately hurt the valuations of those high-multiple stocks if the back end starts to move with the tapering announcement officially. But I think the other risk that people don't talk about much for those stocks is that these were some of the prime beneficiaries of the work-from-home phenomenon. And I do think people are being a bit complacent around the payback in demand for some of these secular growers.

Doesn't change the secular growth story, but they are still inherently cyclical to some degree. And there could be some payback in those earnings estimates over the course of the next two quarters. And I think that's the bigger risk than it is, say, valuation or rates.

JULIE HYMAN: And Mike, finally, I want to come back to this idea of a potential 20% correction and the fact that we haven't seen it because what you're talking about with the fire or ice scenario is obviously going to be a little bit more gradual to emerge. Do you think that there is any risk of a catalyst that could trigger that correction? What would your contenders be?

MIKE WILSON: Yeah, well, I mean, look, first of all, I think the 10% correction is very normal course of business. And we should always expect a 10% correction at any time. So that's not really-- I mean, people make a big deal that when we say 10% correction. That's not really a call. I mean, you should always be expecting a 10% correction. If you're investing in equities, you should be prepared for that at any time.

A 20% correction, which is really more disruptive, where people might want to try to position for, I think the catalyst for that is going to be, once again, the ice scenario. And the catalyst will be earnings season, where we learn from companies that there's been a bunch of double ordering, that inventory builds, perhaps, are bigger than what people are anticipating because demand has been overstated.

And that's really core to our thesis. We think that basically, there's been a period of overconsumption and over-earning over the last year for a lot of different reasons. And there's going to be a payback in that regard that's going to be greater than normal.

There's always payback in any economic recovery scenario. That's the mid-cycle transition. But this time, it could be more acute. And that's what would lend itself to a bigger correction because the earnings estimates would then have to come down as opposed to flattening out.

BRIAN SOZZI: All right, we'll leave it there for right now. Mike Wilson over at Morgan Stanley, chief investment officer, good to see you. Have a great weekend. Really appreciate the market thoughts.