The Bear Case: Morgan Stanley Sticks to 1,167 S&P 500 Forecast

The S&P 500, perhaps suffering from some performance anxiety today, closed 1.8 points lower. The decline erased the possibility that the index would notch a seventh straight day of gains for the first time since 2006.

Nonetheless, the market is clearly on a roll, with the S&P and the Dow both posting five straight weekly gains. Last week the S&P crossed 1,400 and it closed today at 1,404.

That has not shaken Morgan Stanley analyst Adam Parker from sticking to his projection that the index will end the year at 1,167 (his probability-weighted target; his base case is 1,214.). Parker sees earnings coming in lower than sell-side analysts currently expect. He is projecting $100 of earnings for S&P 500 companies in 2012 (consensus is $104) and $99 in 2013 (consensus is $115).

Parker’s clients are apparently perplexed by his prediction; in a note today, he listed the four main questions he gets.

“Doesn’t everyone know sell-side estimates are too high and therefore the buy side is ahead of the sell side?” The question implies that investors are already on to the fact that the sell-side is way too optimistic and won’t be surprised if companies post disappointing earnings.� In fact, sell-side analysts have historically issued expectations that prove to be too pessimistic, says Parker. Thus, investors may be blindsided by weak earnings this year and next.

“Isn’t the fiscal cliff already discounted since it is so well documented?” Morgan Stanley hasn’t even factored the fiscal cliff into its already-low earnings estimates. If Congress can’t find a compromise in its budget impasse and drastic cuts are put in place, the country will probably fall into recession in 2013.

“Isn’t the US the best house on a bad block, and therefore from the asset allocation perspective won’t it keep winning?” Nope again, says Parker: “[O]ur sense is that the pendulum has swung too far towards US equities and away from the emerging markets. A year ago, investors were asking us for US stock ideas with high exposure to emerging markets, believing the promise of higher EM growth was a positive. Now, investors want that list to SHORT the same stocks, believing that EM growth is poised to remain much lower. Our guess is that six months from now, the pendulum will have swung away from the US again and towards the emerging markets.”

“Aren’t the huge cash balances a positive?” Parker’s clients are referring to the huge stockpiles of cash on company balance sheets. Unfortunately, the market has mostly punished companies that have put that cash to work in the past few years, leaving some executives feeling gun-shy about spending it on anything other than buybacks, Parker says. Using cash to invest in a business or hire people could boost the entire economy, but there’s no guarantee it will be deployed to do that. Also, net debt has been on the upswing, which affects companies’ capital plans.

It’s not all doom and gloom. There are stocks and sectors where Parker thinks investors can ride out the storm. The Morgan Stanley team team recommends investors load up on health care and energy stocks like Cardinal Health (CAH) and Schlumberger (SLB), as well as a select group of other names including JPMorgan Chase (JPM) and Freeport-McMoran (FCX).