Wall Street is crowing about the return of the bull market. But don’t pop the cork just yet. Some bearish analysts are warning that the stock market could be in for a sharp selloff.

Michael Wilson, Morgan Stanley’s chief investment officer, believes the market is something of a house of cards. He thinks lower corporate earnings and rising interest rates will divert investor cash from stocks into bonds.

“The headwinds significantly outweigh the tailwinds and we believe risks for a major correction have rarely been higher,” Wilson wrote in a client note in late June.

Lousy risk-return trade-off

Wilson isn’t alone. Many Wall Street analysts agree that the stock market rally is over-dependent on tech mega giants—Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta.

Take those out, and the market has been flat, according to a Financial Times analysis.

But Morgan Stanley goes a step further—arguing that investors are overshooting with 2023 earnings. Wilson expects the earnings per share (EPS) of the S&P 500 to be $185 this year, compared with the average estimate of $220.

A lot of factors go into earnings forecasts. One of the biggest is the size of profit margins.

Margins since the pandemic have been persistently above average. But there has been some evidence that they are returning to normal, taking some of the shine off rosy earnings forecasts.

For example, in the first quarter, Tesla’s gross profit margin fell 10% from the year-earlier period to 19.3%, as the EV maker cut prices to boost market share.

Wilson said that deteriorating pricing and sales would cause companies to fall short of optimistic earnings forecasts.

Stocks are already expensive

Lisa Shalett, CIO of Morgan Stanley Wealth Management, argued in the June 26 report of the firm’s Global Investment Committee that stocks are already too expensive.

The chart below shows that 10-year rolling returns on the S&P 500 have been reasonably stable since the 1960s, with occasional extremes. But the cost of those returns has varied a lot.

That cost is measured by the Shiller CAPE ratio, a seasonally adjusted price-earnings (PE) ratio. A PE ratio shows how investors value a company’s earnings—and, as a result, how they value the company itself. A company with a 10x PE ratio is more valuable, in investors’ eyes, than one with a 5x PE ratio.

This ratio (light brown line) is now higher than at any time since right before the Great Financial Crisis (GFC) in 2008, and during the Covid bull market.

stock market is expensive

With inflation still worryingly high, a recession still possible, and the possibility that earnings forecasts are overstated, it’s no wonder bears think stocks are overpriced.

Stock returns have fallen

Wilson’s second point—that rising rates will spur investors to move from stocks into bonds—is supported by another chart from Morgan Stanley:

stock market is expensive 2

This chart shows the S&P 500’s earnings yield (or what you earn from stocks in yield terms ) minus the yield on the three-month Treasury bills. In simple terms, it’s a premium for risking money on stocks.

Since last year, this premium has vanished because the Fed has raised rates by 5%, while the stock market’s yield is in decline. The result is currently negative.

That means three-month Treasury bills are technically earning more than the S&P 500.

And remember, short-term Treasuries essentially have no risk—unlike stocks. With even a small chance of a recession on the horizon, bears think Treasuries look like the smarter investment.

Will this be a repeat of the 2008 suckers’ rally?

If Wilson and Shalett are right, we could be in a “bear market rally” similar to ones that led to the dotcom meltdown and 2008.

In a bear market rally, stocks rebound briefly, drawing in investors who want to recoup their losses, pushing stock prices up for a while. But prices eventually reverse course.

That’s why these markets are called “suckers’ rallies” or “dead cat bounces.”

With the Fed calling for more hikes this year, inflation at still more than twice the central bank’s target, and with stock yields failing to justify their lofty prices, it could, in fact, be the case.

Morgan Stanley’s bears might turn out to be wrong, but it would be unwise to completely ignore their warnings.