Mike Wilson, Chief U.S. Equity Strategist and Chief Investment Officer for Morgan Stanley, has turned slightly more upbeat on the stock market in a notable shift for one of Wall Street’s biggest bears. Wilson now calls the market’s recent rally a “policy-driven” one, referring to expectations about the Fed’s next moves on interest rates. His comments highlight how outlooks have markedly improved despite ongoing concerns.

The S&P 500 has surged 28% from its early October low, defying forecasts that the Federal Reserve’s aggressive rate hikes would trigger a recession. The Fed has raised rates to combat high inflation by reducing demand. But the expected recession hasn’t materialized, allowing stocks to rise.

Investors are looking past potential economic damage from higher borrowing costs. They anticipate an end to the Fed’s rate hikes and forecast strong consumer demand and corporate profits in 2023. Still, risks linger as stocks grow more expensive while rates stay elevated.

The S&P 500 now trades at nearly 20 times expected earnings, up from 15 in early October. Analysts have reduced profit forecasts amid weaker growth. Further slowing could bring more downgrades. And despite moderating, inflation may initially limit spending as companies curb price hikes. This could squeeze profit margins before improving consumers’ purchasing power.

Falling inflation with still-high rates informed Wilson’s recent shift. His S&P 500 target is 4,200 by mid-2023, an 8% drop. But he warned stocks could plunge 19% to 3,700 in a worst-case scenario.

Previously in 2022, Wilson issued multiple warnings about market vulnerability. But his August 1 note didn’t mention downside risks, calling the rally “policy-driven” like in late 2018 and 2019. Back then, stocks rose on expectations for easier Fed policy, then kept gaining as rates were cut.

Wilson noted that while the Fed may not cut rates in 2023, the “2019 analogy suggests more index level upside.” He added: “We’re open-minded to this view eventually materializing, but we’d like to see more business cycle indicators improve.”

Specifically, Morgan Stanley wants to see broader market participation. The equal-weight S&P 500 ETF (RSP) trails the main index, indicating reliance on big tech. If those stocks falter without offsetting gains, the overall index will decline.

Another bullish sign would be short-term rates falling, which could support growth. But Morgan Stanley hasn’t raised its S&P target yet, unlike some competitors. It is monitoring for factors that would justify an upgrade.

The key takeaway is a longtime bear nodding to the market’s momentum. Perhaps this is the start of a new bull run after all. With sentiment improving, investors may have reasons for renewed optimism if the economy cooperates.

Fed Policy Hopes Power Stocks Higher

The S&P 500’s 28% rebound from its October low has been particularly impressive given the Fed’s rapid interest rate hikes to tame inflation through reduced economic demand.

Rate increases can hit growth with a lag, casting doubt on the rally’s sustainability. But the feared recession has yet to emerge, enabling stocks to climb.

Investors are anticipating an eventual pause to rate hikes and potential cuts in 2024 as inflation falls. The Fed’s recent comments point to a “higher for longer” stance on rates, but markets are pricing in easing by late 2023.

If inflation keeps moderating, policymakers may need to boost demand to avoid deflation. This could necessitate lower rates, fueling additional market gains.

Valuations Rise Alongside Earnings Uncertainty

The S&P 500’s price-to-earnings ratio hit nearly 20 in recent weeks — up sharply from 15 in October. Higher valuations in a risky environment have revived bubble concerns.

Meanwhile, analysts have reduced 2022 EPS forecasts amid weaker growth projections. Slowing economic activity could bring further downgrades, weighing on stocks.

There are also questions around the pace of margin recovery as inflation decreases. If companies are slow to cut prices, consumer spending may initially suffer. But abating inflation should eventually boost households’ purchasing power.

Wilson Still Sees Downside Risk

Despite his marginally improved outlook, Morgan Stanley’s Wilson reiterated a target of 4,200 for mid-2023 — about 8% below current levels. His worst-case scenario is a 19% plunge to 3,700.

Wilson wants to see more indicators like manufacturing data and inventories reflecting economic improvement before predicting upside. He also highlighted risks related to weaker overseas growth and a strong dollar.

But the shift in tone from the longtime bear indicates probabilities may be tilting more favorably. Wilson compared today’s “policy-driven” rally to late 2018 and 2019 when stocks anticipated Fed easing.

Cautious Optimism May Be Warranted

The S&P 500’s surge on hopes for a less aggressive Fed certainly seems reminiscent of past cycles. With inflation appearing to peak, the backdrop looks more supportive.

But risks remain until concrete evidence of slowing inflation and stronger growth emerges. Morgan Stanley is right to avoid overt bullishness before seeing broader participation and business cycle confirmation.

Still, the tenor is changing as markets display resilience. Investors should watch for improved outlooks from other skeptics as potential confirmation of trend shifts. If data strengthens, this policy-driven rally could have further to run.

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