edge of cliff

  • Morgan Stanley says we’ve reached the “euphoria” stage of the 8 1/2-year equity bull market, which is usually the final leg of a rally.
  • The firm sees financial conditions tightening, and argues that GOP tax reform is already priced into the market.

For an equity bull market, overconfidence can be the kiss of death.

This can be seen in a cycle that’s played out repeatedly throughout history. At a certain point during an extended stock rally, investors get cocky and continue to pile head-first into positions with little regard for risks. Then the market faces a drastic reckoning, leaving those traders wishing they’d been more careful.

Simply put, when investors start to feel invincible, bad things happen. To Morgan Stanley, this so-called “euphoria” stage marks the beginning of the end of a bull market. And guess what? That’s where we are right now.

In its 2018 equity outlook, Morgan Stanley makes it clear that we’ve gotten ahead of ourselves. Those extended conditions, combined with earnings growth that’s forecast to plateau in the first six months of 2018, has the firm feeling cautious.

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“Financial conditions will tighten this year, and we can no longer say that investor sentiment and positioning is muted,” Mike Wilson, Morgan Stanley’s chief US equity strategist, wrote in a client note. “In fact, there are now signs we have entered into the ‘euphoria’ stage of this bull market.”

It’s a continuation of comments Wilson made in mid-December, when he asserted that “no cyclical bull market has ever ended without some excitement from investors.”

Still, Wilson is not calling for the end of the bull market — at least not right this instant — since, as he notes, this euphoric stage can last for a while. He’s simply warning that further upside may be limited, and that any remaining gains will be more speculative.

If there is an immediate threat to lofty stock valuations, it will likely be investors overestimating the effect of GOP tax reform going forward, says Wilson. He believes that it’s been almost entirely priced into the market already — a view that conflicts with those held by many of his Wall Street counterparts.

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This skeptical commentary matches Wilson’s 2018 S&P 500 price target of 2,750, which is among the lowest on Wall Street. It’s also just 0.5% higher than the equity benchmark’s current level.

Rather than continue to chase new highs in the US, Wilson recommends looking for opportunities overseas.

“After a long period of US dominance, we believe both Europe and Japan can outperform the US in 2018 and beyond due to the meaningfully lower valuations and potentially faster earnings growth,” he wrote. “These countries are much earlier in their economic recoveries from the financial crisis.”

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