Morgan Stanley attributed the rally to short covering, and the “January effect” – a seasonal pattern that boosts the prior year’s biggest laggards. This trend can often be more acute following a period of weak returns as was the case in 2022.
In fact, the broker labelled the rally another bear market trap, fuelled by investors abandoning their fundamental discipline for fear of falling behind the market’s performance or simply missing out on gains.
The warning comes as the Federal Reserve prepares to raise its benchmark federal funds rate by an expected 0.25 percentage points on Thursday morning (AEDT). Such a move would mark the second straight meeting the US central bank has dialled back the size of its policy rate increase.
While Morgan Stanley agrees a pause in the Fed’s tightening cycle is imminent, it reminded investors that the US central bank is still undertaking $US95 billion a month of quantitative tightening, and is potentially far away from cutting rates.
“A Fed pause is undoubtedly worth some lift to stocks but once again we want to remind readers that both bonds and stocks have rallied already on that conclusion,” Mr Wilson said. “That was the call in October, not today.”
Investors “seem to have forgotten the cardinal rule of ‘Don’t Fight the Fed’. Perhaps this week will serve as a reminder”.
The impact of the Federal Reserve’s aggressive policy tightening is showing up in Wall Street’s fourth quarter profit season where earnings are proving worse than feared, especially in relation to margins.
Morgan Stanley pointed out that margin headwinds are broad-based, with cost growth rising faster than sales growth for around 80 per cent of the S&P 500’s industry groups.
This is causing margin pressures to worsen and will likely lead to earnings per share contraction this quarter for the first time since the COVID-19-induced recession, the broker predicted.
“It’s important to note that typically when forward earnings growth goes negative, the Fed is actually cutting rates,” Mr Wilson said. “That’s not the case this time around… an additional headwind for equities.”
‘Fade the rally’
JPMorgan also advised investors to sell the new year rally in stocks because the risk of a recession remains high, even though the timing of its arrival has been postponed due to tightness in the US labour market.
The weak trajectory for US demand, which has been illustrated during reporting season, keeps the risk of a downturn elevated, the broker said.
Of the S&P 500 companies that have announced fourth quarter results so far, the blended earnings decline, which combines actual results for companies that have reported and estimated results for those that haven’t, is down 2.7 per cent compared to a year ago.
That is below the 1.6 per cent decline that was estimated at the beginning of the year, highlighting that there has been a negative earnings surprise since the start of the reporting season. JPMorgan noted that this is unusual.
“Our stance is ultimately that one should end up fading the year-to-date up-move as the first quarter will likely mark a turning point,” said JPMorgan strategist Marko Kolanovic.
“The fundamental confirmation for the next leg higher might not come, and instead markets could encounter an air-pocket of weaker earnings and activity, as they move through the second and third quarters.”