Morgan Stanley: Here’s a big reason to have confidence in the rally

With more than a few folks on Wall Street warning that market euphoria is approaching ludicrous speed — SPACs! Meme stocks! Call options! Crypto! Mongo multiples! — analysts at Morgan Stanley are out this morning with a pretty bullish note spotlighting one reason why this rally may have some substance to it.

Mike Wilson, the bank’s chief US stock strategist, wrote that the plunge to the brink of a bear market back in April may have marked the end of what he describes as a “rolling earnings recession” over the last three years, rather than the start of a subpar period for stocks.

During these three years, he wrote, earnings for many companies were falling compared to peak profits generated as a result of price hikes they pushed through in 2021 and early 2022, when inflation was romping.

But now, after three years of relatively muted inflation and wage gains for workers — as well as corporate tax cuts from President Trump’s “big, beautiful bill,” and the chance that the Fed cuts early next year, among other reasons — the backdrop for stocks looks much better, with relatively easy year-over-year comparisons. Wilson used one of his favorite metrics, “earnings revisions breadth” (the chart above) as a a cornerstone of his thesis.

He wrote:

“In many ways, the capitulatory price action and EPS estimate cuts we saw in April of this year around Liberation Day represented the end of a rolling recession under the surface of the equity market that began in 2022...

Now, we are transitioning from that rolling earnings recession backdrop to a rolling recovery environment. The combination of the earnings/cash flow drivers listed above, the easy comps fostered by the rolling EPS recession and the high probability of the Fed re-starting the cutting cycle by Q1 of next year should facilitate this transition.

The upward inflection we’re seeing in earnings revisions breadth confirms this process is underway and suggests that returns for the average stock are likely to be quite strong over the next 12 months.”

To be sure, Wilson hedges his position, noting the rally is not without risks and there could be volatility ahead. But he expects pullbacks to be shallow, adding, “We’re buyers of dips.” He also said he’s now “leaning” to the bullish end of his price target range for the S&P 500 (SPDR S&P 500 ETF) which would put the index at 7200 over the next 12 months, a roughly 12% premium to the current price.