Morgan Stanley shares a chart that fuels the argument for new stock-market highs
Morgan Stanley is growing more optimistic about the stock market as earnings revisions breadth improves.
Improving breadth is being driven by more upward revisions, the bank said.
The market is likely to overlook softer hard data in favor of forward-looking views of strong earnings.
The vibes in the stock market are improving, and it's boosting the case for prices to rise from here.
That's according to a note from Morgan Stanley's Mike Wilson. The bank's CIO and chief stock strategist pointed to a key signal that's sending a bullish signal: a sharp rebound in earnings revisions breadth, or the proportion of analysts who have raised their estimates minus the proportion who have lowered them.
The indicator is now at -10%, a noticeable improvement from -25% during the height of tariff uncertainty in April, an indication that sentiment is recovering.
The bank believes the indicator will continue to trend upward. A weak dollar could further bolster this earnings gauge, as US companies that do a lot of business overseas receive a boost in sales when the dollar is weaker. Once earnings revisions breadth turns positive, investors should expect forward EPS predictions to trend higher.
Earnings revision breadth can be driven by either fewer downward revisions or more upward revisions. According to Morgan Stanley, the latter is the case today, which is good news for investors.
More upward revisions tend to result in stronger overall stock market performance, historically leading to a 13% increase in the S&P 500 over a 12-month span. When fewer downward revisions are the driving factor, the S&P 500 has historically returned 8% over the next 12 months.
Morgan Stanley's 12-month price target for the S&P 500 is 6,500, a potential gain of 8% from current levels.
Investors should pay more attention to the improvement in forward-looking earnings revision breadth rather than lagging hard data, according to Morgan Stanley. The bank sees April stock market lows as the end of a year-long trend of downward earnings revisions, and expects the rate of change on earnings revision breadth to be the primary driver of equity prices going forward.
"In our experience, when revisions breadth is accelerating in a V-shaped manner from an extreme low, equity markets typically remain supported and pullbacks remain shallow and unsatisfying (like the past 6 weeks)," Wilson wrote.
The recent outperformance of cyclical stocks also points to a market more focused on forward-looking earnings revisions than backward-looking hard data. These areas of the market are especially sensitive to economic growth and earnings, and they're picking up momentum and providing a tailwind to the overall stock market.
While it's possible that inflation could creep up over the summer as the pull-forward effect of tariffs fades, Morgan Stanley believes the bulk of the tariff pain appears to be already priced in following the April 2 tariff announcements.
Policy headwinds should ease soon, as Trump's term began by front-loading disruptive tariff policies and will transition to more pro-growth initiatives like deregulation and tax cuts.
Over the last month, the market has has rallied over 20% from April lows despite a first quarter GDP contraction weakening manufacturing data. As long as earnings revisions breadth continues trending upwards, Morgan Stanley believes the stock market will continue to overlook short term weakness in hard data.
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