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June
06
2022

Don’t get too excited about the stock market’s recent rally. Some Wall Street experts say it could be a trap—and the bear market will still wreak havoc
Will Daniel

The stock market is suddenly looking up. Or is it?

Equities whipsawed throughout the month of May as investors contemplated falling economic growth projections and less-than-stellar earnings forecasts from retailers.

Despite the bearish news, ongoing volatility, and consistent predictions of an impending recession, the S&P 500 ended the month roughly unchanged after mounting a recovery over the last few weeks.

The rebound has some on Wall Street arguing that it’s time to be opportunistic and buy beaten-down names that still possess strong fundamentals, but not every investment bank is telling its clients to go out and buy stocks.

In a Tuesday research note, a Morgan Stanley team led by chief U.S. equity strategist Michael Wilson argued that stocks’ resurgence in the second half of May was nothing more than a typical bear market rally.

“Bottom line, our base case remains that last week's strength will prove to be another bear market rally in the end,” they wrote. “We see maximum upside near 4250–4300 in S&P 500 terms with Nasdaq and small-caps likely to rally more on a percentage basis as is typical during such rallies.”

To their point, bear market rallies are common historically.

In a Wednesday research note, Bank of America Research strategists, led by Savita Subramanian, noted that 65% of bear markets have seen a rally of 10% or more since 1929, but rallies are typically followed by further pain for investors.

“Of the prior 26 bear markets since 1929, 17 (65%) had rallies of more than 10%, occurring 1.5 times on average per bear market,” the strategists wrote. “The 1932–33 bear market, which lasted 116 trading days, had six distinct 10%+ rallies.”

The Bank of America strategists said they see “reasons to be constructive” on stocks in the near term, but also argue more volatility lies ahead. They recommended clients tilt their equity exposure to “high quality” names with strong earnings, defensive yield players, and companies with pricing power that might benefit from inflation.

And Morgan Stanley was even more pessimistic.

Wilson and his team stood by their prediction that the S&P 500 will fall to 3400 by mid-August, or around 18% from current levels, despite the stock market’s recent rebound.

The strategists said the current bullishness in equity markets is largely a result of investors' belief that stocks have been “oversold” and that the Federal Reserve may be contemplating a pause in its interest rate hikes in August, but they believe investors are underestimating the central bank’s willingness to “shock markets” with interest rate increases in order to get inflation under control.

“The bottom line is that inflation remains too high for the Fed's liking, so whatever pivot investors might be hoping for will be too immaterial to change the downtrend in equity prices, in our view,” they wrote.

The Morgan Stanley team also argues that the Fed will be tightening its monetary policy into an economic growth slowdown and that earnings estimates from corporations remain too high. If they’re right, buying the rally might not be the best move for investors.

Wilson holds a 3900 12-month price target for the S&P 500, which represents a potential 5% downside from current levels.

“None of this assumes an economic recession, which will only make the downside worse,” he added.

Will Daniel is a reporter at Fortune, covering markets and the economy. Will previously worked at Markets Insider and has an MS in Business Journalism from Arizona State's Walter Cronkite School of Journalism and Mass Communication. He is a Manchester United fan. Follow all of Will's stories here. 

fortune.com