Morgan Stanley says ride the raging bull

Morgan Stanley’s analysts suggest running with the bulls this week. They recently announced that they expect the S&P 500 to rise 15% in the next twelve months and possibly to reach 3,000, a gain of 27.4%. They wrote, 

Although optimism is a late cycle phenomenon, history tells us the best returns often come at the end."

Essentially, they are shouting “the end is near!” but “party while you can!” They credited President Trump for their optimism:

While acknowledging that the pro-business agenda of President Trump has awakened "animal spirits" in the economy, the Morgan Stanley strategists feel that Trump has simply "turbocharged" a global business recovery that already has been underway since the first quarter of 2016. They note that one of the worst economic contractions in 30 years, as measured by U.S. GDP, bottomed out a year ago. Since then, their favorite economic indicators have been accelerating, including those capturing business conditions, business outlook and global trade.

I’m not sure what they meant by GDP bottomed out a year ago. According to the official keeper of GDP statistics, the Bureau of Economic Analysis, GDP bottomed out in 2009. They may refer to a short term minimum. Still, a lot of people have jumped on the Trump trade band wagon. Also, they noted that a lot of people expect profits to rise.

As far as S&P 500 earnings are concerned, Morgan Stanley reports that the current 12-month forward consensus estimate is $135.10, and projects that this figure will reach $142 by August and $147 by December. They extrapolated based on current bottom-up earnings estimates and consensus earnings trends.

Finally, Morgan Stanley gurus said they expect PE ratios to remain aloft and advised investors to divorce PE ratios and embrace the Equity Risk Premium instead.

Moreover, they do not believe that the current forward P/E of roughly 18 on the S&P 500 is excessive, in light of today's exceptionally low interest rate environment. Indeed, they find it conceptually invalid to compare P/E ratios today to, say, ratios in the early 1980s when interest rates were in double digits.

I’m clearly not as smart as Morgan Stanley analysts or I would be earning an equivalent income. So I will rely only on the ideas of economists much smarter than either of us – Mises and Hayek – to critique Morgan Stanley’s forecasts.

The idea that optimism drives an economy is pure Keynesian economics, with some Minsky thrown in. Keynes guessed that businessmen are driven by “animal spirits” because he was too lazy to try to figure out what determines their decisions to invest and he needed an excuse for the state to take control of the economy. In reality, businessmen invest when they think profitable opportunities exist. Recently, profits had declined until the fourth quarter of last year when Christmas season gave retailers a bump.

Morgan Stanley analysts place a lot of weight on consensus opinions, so we should notice that consensus forecasts of first quarter GDP are coming in undeer 1%. It’s hard to see how businesses are going to squeeze more profits with GDP growth being so low.

Like Morgan Stanly, many investment analysts have pointed out that the yield on stocks is still higher than on bonds so there is no reason to panic. But bull markets don’t end because the yield or PE ratios get out of line with those of bonds. Bull markets depend on economic expansions. Recessions decapitate bulls. Recessions happen when business profits fall enough that managers quit investing and some declare bankruptcy. Peter Schiff reminded us of bankruptcies recently:

That hissing sound you hear is the air coming out of the retail bubble. According to a recent CNBC report, nine retailers have already filed for bankruptcy in 2017. That equals the total number of retail bankruptcies in 2016 and puts the industry on pace for the largest number since 2009, when 18 retailers went belly-up in the wake of the 2008 financial meltdown. The number of retailers on Moody’s distressed list is also at its highest level since the Great Recession.

Finally, investors should be skeptical of innovative metrics like Morgan Stanley’s Equity Risk Premium. In Financial Bull Riding I wrote this:

If stock prices remained tethered to earnings, stock prices would level off. To prevent that, the media send in the clowns. Remember that rodeo clowns [now called bull fighters] distract the bulls to prevent them from stomping the cowboy into the arena dirt, but in the market, the clowns distract the investor. The clowns pull from their shirt sleeves old tricks to make the fundamentals look better. They use performance measures that rely on creative accounting, alternative profit measures and pro forma statements, and complicated valuation techniques. The clowns break the reflexive loop so that prices continue their ascent unrestrained by fundamentals. If the market was an actual rodeo, the clowns would be lynched for letting the bulls pulverize the cowboys.