Morgan Stanley analysts predict a brutal year-end for stocks

A leading strategist at Morgan Stanley is bracing his clients for a brutal year-end for stocks.

In an Oct. 16 note, U.S. equity strategist Michael Wilson doubled down on his forecast that the S&P 500—America's key stock benchmark—will finish the year at 3,900.

That would mean an 11% drop from today's levels, bringing the index to a mere breakeven for 2023.

Such a scenario seemed improbable during the summer when the S&P 500 hovered near 4,600. According to Wilson, that was before consumer confidence began to wane and Wall Street slashed its profit estimates.

The strategist also threw cold water on the notion that stocks will rally in the fourth quarter because of seasonal factors.

"Our sense from speaking with investors is that a majority still believe a 4Q rally is more likely than not,” Wilson wrote. “[T]his sentiment is contingent on price holding up in the short term,” which he doesn’t think is likely given the S&P 500’s recent performance and the economy’s worsening condition.

Wilson’s bearish outlook will disappoint the bulls hoping for a solid stock rally to close out the year. Unfortunately, a closer look at corporate profits suggests he may be onto something.

Corporate profits in decline

While Corporate America is crawling back to profitability after a year of declines, the picture remains bleak, according to data provided by FactSet.

In the second quarter, the earnings of S&P 500 companies declined by 5.2% annually—the steepest drop in almost three years. And while the last quarter is closing out in positive territory, the reported earnings have barely mustered 0.4% year-over-year so far.

Looking beyond the S&P 500, there’s strong evidence that corporate profitability is declining across the board.

In August, the Commerce Department reported that after-tax corporate profits declined by 9.4% annually in the second quarter. Economists blamed slower economic growth and a shift in consumer spending for the decline.

An unlikely catalyst

Not everyone is convinced that stocks are heading lower in the coming months. Tim Hayes, the chief global investment strategist at Ned Davis Research, believes stocks are waiting for a green light from the bond market.

In an interview with MarketWatch, Hayes said that “excessive pessimism” in the bond market is in the process of peaking, and there will be a “decisive reversal” leading to lower yields and a boost to stock prices.

Bond yields are an important driver of stock prices because, in theory, higher yields lessen the appeal of riskier stocks. And vice versa.

While long-term yields continue to rise, experts believe rates will decline by year-end.

Despite being proven wrong so far, analysts polled by Reuters as recently as last week say bond yields will probably start to reverse course sooner rather than later. That could be the green light Hayes is referring to.