The stock market’s renewable sources of optimism have been exhausted, according to Morgan Stanley’s Mike Wilson.
“The puts have expired,” Wilson writes in a note to clients published Monday. “2019 has been a game of deteriorating fundamentals versus a pivoting Fed and hope for a resolution to the U.S.-China trade uncertainties.
“With the Fed’s first rate cut in a decade not having the desired effect on markets and a trade deal looking less likely every week, these two puts (the Fed and Trade Deal) may have expired, leaving investors facing the potential reality there is no second half rebound coming.”
Eight months of magical thinking in financial markets, in other words, have come to an end.
Last week, the stock market endured its worst day of the year with the Dow (^DJI) dropping 800 points on Wednesday and the Nasdaq falling 3% after an inversion of the Treasury yield curve. An inversion of the yield curve in which the yield on 2-year Treasury notes climbs above the yield offered by 10-year notes has occurred before each of the last seven recessions.
This inversion, along with heightened trade tensions and a slowdown Europe’s economy, enflamed fears over an impending recession in the U.S.
“The Fed put appears to have expired two weeks ago while the Trade put may have expired last week,” Wilson writes. “We do not think this is mid cycle and neither do the markets. Reduce secular growth stock exposure now.”
When the Federal Reserve cut interest rates on July 31, Fed chair Jerome Powell said the move was a “midcycle adjustment” to policy, rather than the beginning of a rate cutting cycle in response to a slowing economy.
Since the Fed’s July 31 decision, however, the S&P 500 (^GSPC) is down about 5.5%.
On August 1, President Donald Trump said that 10% tariffs would be imposed on $300 billion worth of Chinese imports. And though this initial tariff imposition was softened somewhat by the administration last week, investor belief in a potentially imminent trade deal has been dashed.
As the S&P 500 moved to record highs in July, many investors cited the Fed’s potential to cut interest rates as supportive for stocks and a sign that “Fed put” remained in place. Meanwhile, a resolution to the U.S.-China trade fight was another pillar for investor bullishness, with stocks rallying throughout June amid hopes of a U.S.-China trade deal at the G-20 meeting.
But investors getting “what they want” — in the form of rate cuts from the Fed and tariff delays from the Trump administration — has not lead to higher stock prices.
In Wilson’s view, investors are no longer willing to overlook softening earnings and a weakening economic backdrop in favor of a friendly Fed and a potential trade deal.
“We think many have been misinterpreting the signals from the market to be a bullish signal for growth when in fact the market has been signaling since April that growth was likely to disappoint,” Wilson writes.
“The S&P 500 is the most defensive, highest quality and liquid stock market in the world, so if it is outperforming strongly, it is likely a bad sign for future growth. The dramatic underperformance of the small cap Russell 2000 and cyclical sectors all year was a clear indication that things were not improving, nor were they likely to this year.”
Myles Udland is a reporter and anchor at Yahoo Finance. Follow him on Twitter @MylesUdland