Morgan Stanley predicts the S&P 500 will reach 7,200 within a year, increasing about 12% based on current levels. This outlook stems from a recovery in corporate earnings, moving away from the earnings recession that started in 2022.
The earnings recovery is driven by factors such as positive operating leverage, AI adoption, a weaker U.S. dollar, and tax savings due to the OBBBA legislation. Other factors include favourable year-on-year comparisons, pent-up demand across industries, and potential Federal Reserve rate cuts by early 2026.
End Of The Earnings Recession
April’s market selloff, influenced by tariff announcements, may indicate the end of the earnings recession. The U.S. seems to be shifting towards a phase of recovery not fully recognised by the market.
Morgan Stanley observes that upward earnings revisions indicate stronger fundamentals. Although some are concerned about high valuations, Morgan Stanley considers them justifiable due to an improving economic environment.
Market sentiment is also lifted by declining macroeconomic uncertainty. A new trade agreement with the EU and potential Fed policy easing later in the year are increasing confidence in market growth. This positive scenario is gaining credibility as earnings momentum builds.
Potential Strategies For Investors
Given this bullish outlook, we believe derivative traders should position for sustained upside in U.S. equities. A straightforward approach is to buy call options on broad market indices like the S&P 500, targeting expirations several months out to capture the anticipated climb. This strategy allows us to participate in the rally with a defined and limited risk.
The earnings recovery Mr. Wilson describes is already appearing in the data, making this a credible thesis to trade on. According to FactSet, the blended year-over-year earnings growth rate for the S&P 500 in Q2 2024 is currently 9.8%, with analysts forecasting double-digit growth for the rest of the year. This statistical evidence supports the idea that the fundamental driver for the market is strengthening right now.
Market conditions are currently favorable for establishing these bullish positions. The Cboe Volatility Index, or VIX, has been hovering near the 13-14 level, which is historically low and makes the premiums on call options relatively inexpensive. We see this as an opportunity to build exposure before a potential increase in volatility makes options more costly.
For those comfortable with the view that a major downturn is unlikely, selling out-of-the-money put options or put spreads is also an attractive strategy. This allows us to collect premium based on the belief that the market will remain stable or grind higher. Even with the S&P 500’s forward P/E ratio being elevated near 21, above its 10-year average of 17.8, the strong earnings momentum justifies this valuation.
The mentioned tailwind from a weaker U.S. dollar is also materializing, as the DXY index has recently retreated from its yearly highs. This trend directly helps the profitability of U.S. multinational companies, which make up a significant portion of the index. Historically, periods that combine accelerating earnings with accommodative central bank expectations have powered markets higher for multiple quarters.
To refine our exposure, we could also look to bull call spreads. This approach involves buying a call option and simultaneously selling another call at a higher strike price, reducing the initial cost of the trade. This is a prudent way to express a bullish view while capping both the potential profit and the upfront capital at risk.
