5 investments Morgan Stanley recommends making as US stocks surge by up to 19% — and why a prominent Wall Street bear just abandoned his downbeat view (2024)

Top minds at BMO Capital Markets bailed on their call that stocks had limited upside by raising their 2024 target to a Street-high 5,600, with strategy chief Brian Belski writing in a May 15 note that "it has become clear to us that we underestimated the strength of the market momentum."

Deutsche Bank then zeroed in on a year-end target of 5,500, with lead strategist Binky Chadha writing in a May 17 note that "while all the growth may not materialize this year, we see market confidence in a continued recovery rising by year-end, supporting equity multiples."

The latest bank to join the ring of bulls also happens to be the most interesting: Morgan Stanley. Long-time market skeptic Mike Wilson, the firm's chief US equity strategist, revised his 12-month base-case target for the S&P 500 to 5,400 from a modest 4,500 just five months ago.

The case for further gains despite risks — and why stocks could soar 19%

Morgan Stanley entered the year expecting solid earnings in a continued economic expansion.

That thesis appears to be playing out despite subpar first-quarter GDP growth and a spat of higher-than-hoped inflation. Most investment firms now agree that a so-called "hard landing" is unlikely, barring an unexpected macroeconomic shock.

"Markets appear to have moved from a 'soft landing' outcome in January to a 'no landing' in March and now back towards a 'softer landing,'" Wilson wrote in a May 20 note.

Wilson's colleagues are also on board with that glass-half-full view, though the strategist said to be wary of groupthink since economic projections have been less reliable since the pandemic.

Profit growth impressed in Q1 and has helped underpin the S&P 500's 11.3% year-to-date rally. The index is now trading at a historically rich price-to-earnings (P/E) ratio of 22.1x, based on a median top-down full-year earnings estimate of $240, according to Goldman Sachs.

US stocks can grow into that seemingly ambitious valuation if corporate earnings remain robust and interest rates fall. Morgan Stanley is calling for profit growth of 8% in 2024 and 13% in 2025, which would bring the S&P 500's earnings multiple to about 19x a year from now. Interest rate cuts, which may come as soon as September, could also eventually lift the index to 5,400.

And if earnings continue to exceed estimates in a strong economy by rising 11% to 15%, Wilson believes the S&P 500 could soar 19.6% to his upside target of 6,350. Valuations would stay high in such a scenario, the strategy chief noted, though that won't always be the case.

"It's very hard to predict exactly when valuations will normalize, but we remain confident that valuation matters in the end and that we are not in a new paradigm that justifies permanently higher P/Es," Wilson wrote.

But while Wilson is no longer one of Wall Street's biggest bears, he shouldn't be mistaken for an optimist either. His 12-month S&P 500 target is just 1.7% above where the index trades, which suggests that US stocks are an uninspiring bet from a risk-reward standpoint.

And if there's a recession after all, investors may wish they ran for the hills. Wilson's bear case is that the S&P 500 plunges 20.9% to 4,200 as earnings fall and the market's multiple contracts.

There's an above-average risk of a downturn, in Wilson's view, since the yield curve is still inverted and key catalysts like stimulus that supported consumer spending are now drying up.

"Government intervention during the pandemic was historically large and created a stock of money that has just taken longer to work through than normal," Wilson wrote. "However, with excess savings fading and many consumer companies sounding more concerned on demand, those stimulus tailwinds may finally be waning."

An unexpected inflation resurgence that causes bond yields to spike is also a potential risk, Wilson wrote, though that would have a smaller impact on corporate earnings.

5 ways to invest with market upside limited

Since few, if any, investors would be satisfied with a sub-2% gain in the next 12 months, Wilson and his team shared five investments that can deliver solid returns in a flat market.

"The uncertain backdrop we face warrants an investment approach that can work as market pricing and sector/factor leadership bounce between potential outcomes," Wilson wrote.

Quality stocks, or operationally efficient companies that have strong balance sheets, headlined Morgan Stanley's list of top investing ideas. The firm recommends pairing cyclicals and growth stocks with those attributes so that investors are prepared for stronger or weaker growth.

If economic growth is slower than anticipated, it will be wise to own stocks in defensive sectors like consumer staples and utilities, Wilson wrote.

Consumer-focused companies were a mixed bag in the Q1 earnings season, as some posted robust reports while others warned that spending is softening. Many households are trading down to cheaper products, which should be a boon for many firms that sell everyday essentials. Plus, the sector's earnings revisions are better than its consumer-discretionary counterpart.

Utilities are another defensive group that should hold up if there's economic weakness, and it should benefit once interest rates finally fall. However, the sector offers much more upside than usual as an underrated beneficiary of the artificial intelligence boom. Technology firms using AI need more power, which is a major long-term tailwind for utility companies, Wilson wrote.

"Both traditional and alternative energy providers have upside revisions potential amid the increasing need for AI data center power and more favorable data center power deals," Wilson wrote. "Our power & utilities team projects data center electricity consumption to rise from 3% of total US consumption in 2023 to ~10% by the end of the decade."

Industrials are also a top choice of Morgan Stanley's. The firm upgraded the group since its earnings have been revised higher, plus it has lagged lately despite strong catalysts like automation, clean technology, nearshoring, and heightened capital expenditures, Wilson noted.

"We see the recent pullback as an attractive entry point and an opportunity to formally upgrade the sector to overweight," Wilson wrote. He's especially bullish on aerospace & defense firms.

Lastly, Wilson likes large caps more than smaller stocks since they have better earnings revisions, margin profiles, and balance sheets, which are attractive attributes in a late-cycle backdrop. And while large caps' valuations are richer, that premium is justified, in Wilson's view.

"Small-cap valuation is relatively cheap but earnings growth is highly concentrated," Wilson wrote. "We think a broad re-rating within small caps is unlikely in a later cycle environment given the aforementioned factors; in other words, this group is cheap for a reason and is likely to remain so, in our view."