Stocks: Two things to watch amid earnings season

Morgan Stanley’s Mike Wilson joins Yahoo Finance Live to discuss earnings season, tech stocks, inflation, growth, and the outlook for the economy.

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JULIE HYMAN: Well, Tesla aside, there are a lot of other earnings that we have been watching, of course, this morning, the likes of which AT&T, American Airlines, Union Pacific, Alaska Air, just to mention a few. And let's talk about the earnings season writ large and how it's affecting what's going on in the markets.

Mike Wilson is with us, Morgan Stanley, US equity strategist and chief investment officer. Mike, good morning. It's good to see you. I know you've been closely watching earnings revisions around the companies that have been reporting. So give us sort of a status report, if you will, where we are in the season thus far and how that's informing your view of the markets overall.

MIKE WILSON: Yeah, good morning, Julie. Thanks for having me. I mean, look, I think it's-- I'd give it an incomplete so far, right? I mean, we're about 20% of the way through. And we will have to go still-- and look, I think the first quarter itself will be fine. I mean, companies do a really good job of managing the quarter that we're in. So there's no reason to think that we're not going to see companies beat what has been a lowered bar.

So one thing I would point out is that earnings did come down over the course of the quarter, earnings estimates for the first quarter, and now companies will likely beat that. It's really about, I think, two things. Number one, what did the companies guide to for 2Q and the rest of the year? I think that will be a real mixed bag. We have some strong views that, like you were just saying, consumer goods companies probably have to lower the bar a bit for obvious reasons. Maybe the services companies could see something tick up. Those are two pretty good examples of differences on the guidance.

But then I think the other thing that we have to really watch is, how does the stocks trade even on good news? Because it's our view that this is pretty much as good as it gets, right? That the margins now are going to deteriorate.

So we're going to be looking at things like inventory to sales growth, Capex and depreciation, operational efficiency, margins, incremental margins in particular. And I think that'll really be stock by stock. And that's how we've been setting up our portfolios. We really-- we're not picking styles or necessarily sectors. We're looking for companies that can operate in what is a very challenging environment, as everybody knows.

JULIE HYMAN: Mike, thus far, what we've been hearing from companies still seems to be not universally, but pretty broadly, strong demand. It seems like most of your concerns lie on the margin side and on the cost side. Is that accurate, or do you think demand is also going to start rolling over?

MIKE WILSON: Yeah, no, it's both, right? So I think that the pressure will show up in margins first because costs are picking up. Companies have had to over order and get more inventory in to meet this surge in demand that we've enjoyed. But then that could be happening at exactly the wrong time, right? We see the supply pick up just as demand is starting to roll over. So, like, a lot of the leading indicators that we look at-- consumer confidence, some of the other leading indicators for the consumer-- tell us that things will slow in the second half.

Now, that doesn't necessarily mean it's a recession. But I do think the risk of a recession has gone up materially, particularly for next year. And that will travel through the multiples, right? So the stocks will figure that out before the economists. And they'll start to mark down the valuations. That's already begun, right? That's been our call this year so valuations would come down. And that valuation derating, how far it goes, will be determined by how much the growth actually slows. Now, obviously, if we're in a recession next year, then those multiples are going to come down a lot more than people think.

BRIAN SOZZI: Mike, is the first quarter likely the last quarter this year that we'll see earnings growth for the S&P 500?

MIKE WILSON: No, I think it's premature to make that call. But I do think earnings growth is going to decelerate further from what is being modeled. So let me just give you a couple of figures that are worth thinking about. So in the fourth quarter, we did 14% net margins at the S&P level. The earnings, as I said before, have come down, earnings expectations for Q1. Now the Street's modeling 12 and 1/2% net margins for Q1. That's a pretty steep falloff.

The problem is that the rest of the year, they have the margins going back up. So I think that will come in. You could still get positive growth. But it's going to be low single digits, maybe mid-single digits at best. And that doesn't justify 19 times earnings in our view.

JULIE HYMAN: Mike, if I'm not mistaken, you think that we're going to see the S&P 500 fall to 4,000. What's the time horizon on that? And is the trigger going to be that we started to see this earnings rollover and more signs of a recession?

MIKE WILSON: Earnings are part of it, right? So that's-- we had this narrative for a while, fire and ice. And the fire part is just as important. That's the Fed and inflation, right? So, obviously, inflation is out of control. The Fed is responding to that. And I mean, let's be honest. I mean, the Fed hasn't really done anything yet, but the bond market has kind of tightened for them. Mortgage rates are a really, really good kind of, I think, precursor to what that tightening is doing to the real economy. Mortgage rates are up 60% since January.

And that is definitely starting to have an impact on mortgage applications and affordability. And housing is so important to the economy that I think that will affect a lot of different companies. Then we have the margin issue. We have a payback in demand issue we've been talking about for a while. That's the ice portion. So it's the combination of the two that's going to take multiples down, right? You have rising interest rates, tighter monetary policy, weighs on multiples. Then you have slowing growth-- that also weighs on multiples.

So the way you get to 4,000 is quite simple. It's basically 17 times earnings, down from sort of 19 times today. It's not a-- we're not looking for the bottom to fall out. 17 times is still a pretty generous multiple, given the setup.

BRIAN SOZZI: Mike, I think you were in our digital green room before, and you saw our-- I'm going to call it the fluffy puffy-- fluffy puppy economic indicator. Am I putting too much stock in that? Those declines are pretty startling. And to me, I think it fits very well with some of the things you're saying on a recession.

MIKE WILSON: No, I mean, look, I think it's a really interesting analysis. I mean, that's exactly the kind of stuff we do. I haven't looked at that particular example, but I mean, look, discretionary-- I mean, we all love our pets. If you have one, OK, we're not going to starve them to death, but you're maybe not going to buy that extra toy, right?

It's a discretionary purchase, no different than the extra thing you're going to buy online or something, have it shipped to your home. Those types of purchases are exactly the kinds of things that we think are going to suffer first. And so I think it is an interesting indicator. Whether or not it means a recession, I think that's a bit of a stretch yet. But I do think directionally, it's right on.

BRIAN SOZZI: Well, a person of your status on Wall Street validates the fluffy puppy indicator. I'm feeling pretty good. This is a good day for me. We'll leave it there. Mike Wilson, chief investment officer and chief US equity strategist at Morgan Stanley, always good to see you.