Is Morgan Stanley's Prediction of a Market Downturn Justified? An In-Depth Analysis

The recent claim by Morgan Stanley that the worst is just ahead for the stock market has drawn considerable attention. While some analysts remain skeptical, there are compelling reasons to consider Morgan Stanley's perspective, especially when examining the historical importance of the trailing price-to-earnings (P/E) ratio.

The Importance of the Trailing P/E Ratio

Much of the skepticism towards Morgan Stanley's forecast stems from a misunderstanding of the trailing P/E ratio. This metric, which measures the current stock price relative to the past 12 months' earnings, is a critical tool for gauging market valuations. Interestingly, the trailing P/E ratio has only exceeded 25 three times in history: in the late 1890s and twice before the 2000 crash. More recently, both the Dow-30 and the SP-500 have been over 25 for an extended period.

However, finding the trailing P/E ratio for the NASDAQ is rather pointless due to the high number of loss-making companies listed there. Despite the allure of high earnings growth, the only way to soothe this elevated P/E ratio is a significant decline in stock prices.

Rising Earnings and the P/E Ratio

The key to understanding the P/E ratio lies in recognizing the dynamics of stock price movements. Rising earnings generally lead to speculation that future earnings will be even higher, which can drive stock prices up. Conversely, lower P/E ratios occur as earnings fall, leading to a collapse in stock prices and thus deflating the P/E ratio.

This relationship might seem counterintuitive, but it is a fundamental aspect of market valuation. When looking at the historical context of the Dow and SP, a 10% decline in prices since their peaks resulted in only a 3% reduction in P/E, with the Dow around 21 and the SP tech-heavy index around 22.

To bring the trailing P/E back to its historical mean of around 16, a 40-50% reduction in stock prices from the peak would be necessary, equating to a 30-40% fall from current levels. This stark reality starkly highlights the potential for further market downturns.

The Impact of Tax Cuts and Trade Wars

While the yield from previous tax cuts may have temporarily boosted the market, the long-term effects have begun to wane. Additionally, the ongoing trade wars have introduced significant uncertainty and risk into the market. These factors, combined with the elevated P/E ratio, raise serious concerns about the future stability of the stock market.

Morgan Stanley's prediction, therefore, is not merely a hunch but is grounded in a careful analysis of both historical trends and current economic conditions. The combination of reduced earnings potential and looming economic uncertainties suggests that the stock market is on the cusp of a significant downturn.

In conclusion, while the path and timing of any market downturn remain uncertain, the current elevated P/E ratio, coupled with the economic challenges posed by tax cuts and trade wars, lends weight to Morgan Stanley's prediction. Investors would be wise to remain vigilant and prepare for potential volatility in the weeks and months ahead.