Stock market: We’re entering a period of ‘negative operating leverage,’ strategist says

Morgan Stanley Equity Strategist Mike Wilson joins Yahoo Finance Live to discuss the July jobs report and whether the bear market in stocks has bottomed.

Video transcript

- Hawkish Fed is good for bonds, but maybe not for stocks. At least that's according to our next guest, who says don't be fooled by the recent uptick in the stock market. Let's bring in Morgan Stanley Chief US Equity Strategist and Chief Investment Officer Mike Wilson. Mike, always great to see you here. Pretty big jobs numbers out this morning. How does that fit into your thesis for the markets?

MIKE WILSON: Yeah, I think the jobs number fits really nicely into our thesis that employers are still hiring at a pretty good clip as they try to navigate what has been a difficult operating environment. Had too much demand. Now they probably don't have as much demand. They didn't have enough supply. Now they have too much supply. They're probably trying to keep things together with more employees where they can.

And this really fits our general view, which is that we're now entering a period of significant negative operating leverage. And it's really the mirror image of what we saw back in 2020 and '21. We recognize an inflation was probably going to surge after the two pronged policy of fiscal and monetary really stirred demand.

And what resulted is excess demand at a time when supply was short and costs were being suppressed. So you had incredible operating leverage. And I would say most companies and the Street missed that extreme operating leverage. And now I think it's the opposite.

I think what's happening is inflation is peaking. People are excited about that for good reason. But be careful what you wish for. Because while that's good perhaps that the Fed may be able to pause down the road, probably not anytime soon with this jobs number. But they will pause at some point because inflation has come down, that will have a disproportionately negative impact on profitability. And we're already seeing that in the second quarter earnings, which is really part of our fire and ice call for this full year.

- Hey, Mike, it's Julie here. So does that mean that just as the market was underestimating the negative effect that inflation would end up having, do you think now the market is underestimating the phenomenon that you're describing? I mean, we have seen certainly on an individual basis negative stock reactions to negative earnings. But the market overall has been climbing.

MIKE WILSON: Yeah I mean, we're still down on the year obviously and we're in a downtrend. So I think this is similar to March. We're having a bear market rally because we got oversold in June. Obviously people got a little too bearish on the second quarter. And then now there's this sort of hope that the Fed can pause at some point, which I don't disagree with that.

And that's all led to multiples re-expanding here from basically 15 times back to 18 times and that's hard to justify. And I think what investors, equity investors, need to really focus on is how much do the numbers or the estimates have to come down for the companies that they're invested in? Clearly in some cases that's already occurred.

But we think at a broad level, at an S&P level, the risk is still somewhere between 5% and 15% in terms of forward estimates. And that's not priced. And our negative operating leverage thesis we think will gain momentum in the third quarter and this jobs report supports that. Because it means companies haven't yet bit the bullet yet on labor. And so that means margins are going to suffer.

- Mike, does this jobs report, is this the trigger point that sends markets below those July lows?

MIKE WILSON: Well, you know I think it does. At the S&P level for the index, I think it will. Now there's a very important sort of, we look at markets a lot of different ways. We were probably early to call a bear market last year because we saw things developing that for the average stock was terrible. So I guess everybody knows the S&P had a good year last year, but the average stock did not.

And we would argue that the June lows was the momentum low. That's where the breadth probably made its lowest point, where most stocks, the average stock maybe made it's low. But the index probably did not. And that's the way it typically works in these bear markets, particularly around recessions if we're going to have one, where you get a momentum low and then you get a price low later on less momentum.

That's your classic divergence. And we suspect that'll happen sometime in the fall. Now obviously we could be wrong. But that's our base case right now. So yeah, we do think those June lows will be taken out of the index level.

But at the stock level, there's probably many stocks that have already bottomed in that June low. And that's the name of the game. We're trying to pick the right spots to be.

- Mike, you're pretty well known as one of the biggest bears out there, I think it's fair to say. And so sounds like you're sticking with this sort of bearish view about making another low. But on the flip side what you just said is interesting, that there are spots here to get into the market. What are you seeing that you like right now? What is making you feel maybe not as bearish as your reputation would suggest?

MIKE WILSON: Yeah, it's funny. I mean I'm either the biggest bull or the biggest bear, seems to oscillate back and forth. So it's a weird phenomena. But anyways, yeah, I think we probably are still probably one of the more bearish. We've been bearish all year.

And look, we've navigated that by essentially going into defensive parts of the market, where earning stability, we think, is most defendable. And that has worked extremely well. The other areas is companies who have what we call operational efficiency. It's kind of a similar metric, but you can do it at the stock level.

And then of course, there are businesses or areas of the market where, and this is more of a bottoms up analysis, where we think companies have businesses that are somewhat diverging from economic growth. So I would say stay away from the really economically sensitive areas. Go for things that have more idiosyncratic growth and stay away from the names that have big components within the index because that's where the pressure is probably going to be the greatest.

Look, at the end of these bear markets it's always tricky. You usually get some sort of capitulation reaction at the very end, which makes it hard to be making money in absolute terms. Don't forget, even the stocks that we think bottomed in June are off those highs. So that doesn't mean they won't go down and retest those levels, but they probably won't break them.

But just keep in mind the last part of these bear markets are usually the most vicious because you finally get that capitulation which we really haven't seen yet. Yeah, we. Saw some selling of course in the spring and people were kind of bearish. But we really haven't seen any true fear. We've seen people kind of more agitated and maybe irritable about losing money, but not really fearful and I think that's still coming.

- Mike, in a recession scenario, if that plays out, do you still see S&P 503,000?

MIKE WILSON: Well look, we can't be that precise. We have to try and give people a framework to think about. And obviously we also can't call a bond to the day. So the way I would think about it is we think that June lows are vulnerable at the index level. We project that in a recession the forward estimates will come down to $195, and that translates into about 3,000 on the downside.

Does that mean you have to wait exactly for that number to start buying? No, of course not. So I would suggest to listeners that you wait for this retest sometime in the fall as the numbers come down. And as we go through the old lows, towards 3,500 maybe, that's where you begin to start accumulating. Because that next low will be the more sustainable one that we think will lead to truly the next bull market, which could be as early as next year.

I mean next year could be a really, really good year if we can kind of just clean up this last part of the bear market.

- Oh, there's a little bullishness. Just really quickly finally, Mike. The fear that you're talking about that would trigger the capitulation, where do you think that fear is going to come from? What's going to trigger that?

MIKE WILSON: Well, if I was that smart you know I probably be a fortune teller. But look, I mean, I think there are obvious candidates that have already appeared this year. We have a war ongoing which could get worse, particularly with the gas situation in Europe. That's a scary situation. Obviously what's going on in Taiwan, we don't anticipate it turning anything really severe. But you never know.

And then of course, we have a lot of leverage in the system still. And whether that's China real estate, whether that's US investors, crypto, and usually there's some sort of financial accident of some kind. At the end, I guess as a recession gets priced, you never know where it's going to come from. I will say, though, just so investors don't get too scared here because we don't want to do that.

We don't think it's a secular bull market. This is not going to be like '08. There's not something structural or systemic in the banking system. So it'll be temporary, and the economy will recover from that, and it will be an opportunity. So we want to make sure we're clear about this. We think there's more downside here again because we've rallied so much.

There could be maybe some sort of financial accident along the way. It won't be systemic. It will be an opportunity. And that's when I think people will be fearful and then maybe we can become the most bullish guy on the street. We'll see how that plays out.

- Well, we look forward to keeping track of all of that and to catching up with you as it goes on. Thanks so much, Mike. Appreciate it. Morgan Stanley Chief US Equity Strategist Mike Wilson. Thanks again.