Equities have rallied again, but investors looking for solid evidence that the bottom is in should keep their eye on these two data points.
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Well into the fourth quarter of what’s been a tough year for markets, many investors are searching for signs of a market bottom and wondering, “Are we there yet?”
The short answer is “Not quite.” While stocks recently staged another rally, Morgan Stanley’s Global Investment Committee believes this latest bounce is temporary, driven by technical factors, and that the bear-market bottom is still to come.
First remember that the nature of this bear market is different from others in recent history. The Federal Reserve’s deliberate tightening of monetary policy, rather than a financial or economic crisis, is driving this downturn.
Why does that matter? During crisis-fueled bear markets—such as the 2001 dotcom bust, the 2008 housing-related financial crisis and the 2020 pandemic-driven crash—a rapid easing of monetary policy was the antidote. This time, however, policy tightening will likely be the cause of economic slowing, as central bankers are forced to combat inflation; historically, this kind of bear market tends to be more prolonged.
So, in a policy-driven cycle, what is the playbook for identifying market bottoms? We believe there are at least two necessary conditions:
- First, inflation needs to reach a viable peak. We may reach that soon. Although uncertainty remains, we see solid indications of both softer demand and more supply, suggesting that inflation is poised to decelerate in the months ahead. Importantly, while peak inflation, and in turn, peak policy rates, may be sufficient to bring the bond market to a bottom, that likely won’t be the case for stocks.
- Stocks may need to fall farther, based on a sober assessment of year-ahead corporate earnings potential. In other words, overly optimistic stock investors and Wall Street analysts must realistically factor in the potential depth and breadth of an economic slowdown and the consequent hit to employment and consumer demand. That forecast reset has just begun, yet the 2023–2024 earnings picture is still far from clear.
With U.S. stocks down about 19% and bonds down 15% so far in 2022, this search for a seemingly elusive bottom can be exhausting. But we continue to encourage investors to remain patient and avoid chasing index-level bear-market rallies.
We see opportunities for stock selection in healthcare, financials, energy, industrials and defense, which are supported by above-average dividend and buyback yields. For passive investors considering U.S. stock exposure, the equal-weighted S&P 500 Index (which holds equal weights of each of its 500 stocks, regardless of how large or small the company is) may be a more reasonable choice than the traditionally capitalization-weighted index (which holds greater amounts of companies with larger market caps), given the potential for the mega-cap tech names to continue underperforming and drag the cap-weighted index down in the process.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from October 31, 2022, “Are We There Yet?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.
