- Stocks have slumped from early-September highs, and the Q3 earnings season could bring more trouble.
- Mike Wilson, Morgan Stanley’s CIO, warns that many firms have already pulled forward demand.
- Here are four stocks to buy in the consumer services industry that have marked upside.
An unknowable amount of digital ink has been spilled on the subject of stock market corrections. Strategists love to tell eager audiences when purported pullbacks are coming and how to prepare for impending downturns, as no investor wants to be caught with their pants down during a selloff.
But Morgan Stanley’s Mike Wilson swims against the tide. The firm’s chief US equity strategist and CIO reiterated in a recent note that while a long-awaited 10% to 20% stock market pullback may be on the way, an invisible, “under the surface” correction has already come.
The average stock in the S&P 500 has corrected by between 10% and 20% this year, Wilson noted, even as the index hasn’t fallen more than 6%. The S&P 500 slid 4.8% in September, its worst month of the year, as the hinted it may soon end emergency support. Volatility rose drastically, with the CBOE Volatility Index (VIX) spiking 40% in the month.
A legion of investors appeared to swoop in and buy the dip, helping the S&P 500 get off to a healthy start in October. But for the first time all year, the strategy didn’t immediately pay off, Wilson wrote, and the broader market may now be in a perilous position as it slips below support levels.
Unfortunately for dip-buyers, the upcoming Q3 earnings season is “unlikely to provide the necessary catalyst” for stocks to take the next leg higher, Wilson wrote in an October 11 note. That’s because Morgan Stanley believes that analysts are more likely to slash earnings estimates in the weeks ahead than boost them.
Earnings revisions tend to be leading indicators, foreshadowing forward earnings growth by about six months, Wilson wrote. Year-over-year earnings revisions are already slowing, Wilson noted, adding that earnings growth could disappoint in the next two quarters.
“We continue to see downside risk to earnings revisions breadth as 3Q earnings season kicks off — a headwind for price,” Wilson wrote. “We see higher labor and raw material costs, supply chain issues, and demand pull forward being key risks.”
So-called “stagflation,” where growth stagnates while inflation takes off, has been a buzzword on Wall Street lately. While BlackRock and Bank of America doubt stagflation will return, the three risks Wilson outlined above indicate Morgan Stanley is likely in the opposite camp, especially if growth recedes more than expected because demand has been pulled forward.
“Decelerating growth is normal during the mid-cycle transition for both the economy and earnings,” Wilson wrote. “However, this time the deceleration in growth may be greater than normal, especially for earnings if not the economy.”
Record earnings and margins are currently baked into earnings forecasts, which leaves plenty of room to the downside for stocks in Q3. There’s “little doubt” that companies “over-earned” in the first half of the year, Wilson wrote, but that doesn’t mean that they’ll acknowledge it.
“Forward earnings estimates will only outright decline if management teams reduce guidance, and while we have several recent examples where this has been the case, we also know most managements will resist it until they are forced to do it,” Wilson wrote. “We suspect many will blame costs, and even sales shortfalls on ‘supply’ constraints rather than demand or pricing issues, thereby giving investors an excuse to look through it.”
Navigating the split in the consumer discretionary sector
A dichotomy will define the consumer discretionary sector in Q3, according to Morgan Stanley. Stocks in the consumer services industry — like hotels, restaurants, and travel companies — are set to gain from pent-up demand, while their consumer goods counterparts suffer from a reversion to the mean after pulling forward demand early in the economic recovery.
Consumer spending on goods is tumbling after rising far above the historic trend, but spending on services is just starting to revive, Wilson wrote. The reversal should continue as spending on goods normalizes because of softening demand, waning government stimulus, and rising prices. In the meantime, consumer services stocks may enjoy their day in the sun.
“In many ways, the pandemic fueled this overconsumption dynamic both as a result of the stay-at-home/work-from-home environment that persisted as well as the Covid stimulus payments that boosted household income,” Wilson wrote.
Below are four stocks in the consumer services industry that Morgan Stanley has an overweight rating on ahead of the Q3 earnings season. Also included are each stock’s ticker and market capitalization, as well as Morgan Stanley’s price target, percent upside, and investment thesis.
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