Stock prices still do not reflect all risks, say Goldman and Morgan Stanley

“The equity risk premium doesn’t reflect the risks to growth, which are increasing due to margin pressure and weaker demand as the consumer decides to dig in,” Morgan Stanley strategists led by Michael Wilson wrote in a note Monday.

Low consumer confidence is a key risk to the stock market and the U.S. economy, while the Federal Reserve is poised to continue fighting rising inflation with rate increases, they wrote.

Meanwhile, Goldman Sachs Group Inc. strategists led by David J. Kostin said U.S. earnings estimates are still too high and he expects them to be revised further down.

Despite this year’s selloff in the S&P 500, “equity valuations remain far from depressed,” Kostin wrote in a note. Surprisingly strong inflation data show “that the Fed’s battle against inflation has put a ceiling on equity valuations.”

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U.S. inflation accelerated to a new 40-year high in May, while consumer confidence plunged in early June to the lowest level since 1978.

Stocks fell Friday and U.S. futures indicated the S&P 500 could approach a bear market again today on investor fears that the latest inflation figures are likely to push the Federal Reserve to extend a series of interest rate hikes into the fall.

Wilson has been among Wall Street’s most prominent bearish traders and correctly predicted the latest market selloff. While Morgan Stanley strategists said the market has discounted margin pressure and declining consumer demand, the risk of an inventory glut is only now beginning to be reflected in stock prices. They reiterated their underweight to consumer discretionary stocks.

Wilson forecasts 3,400 points, or about 13% lower than Friday’s close, as a “more reliable support level” for the S&P 500 in mid- to late August if a recession is avoided-which represents gains 3% to 5% lower than consensus, a 10-year Treasury yield of 3%, and an equity risk premium of 370 basis points.

Goldman’s base case is that equity valuations will remain roughly flat, while earnings growth will boost the S&P 500 to 4,300 by year-end, or about 10% higher than current levels.