The Market Shift Investors May Be Missing

0:00Mike Wilson:Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley CIO and Chief U.S. Equity Strategist. Today on the podcast, I'll be discussing the changing equity market leadership. It's Tuesday, June 30th at 1130 a.m. in New York. So let's get after it.

0:18Mike Wilson:Something is happening in plain sight, but still isn't fully appreciated by investors. The market's leadership is changing. And as usual, by the time everyone agrees that it's happening, the easier money will probably have already been made. Coming into this year, the primary differentiation to our view was that the economic and earnings outlook were much stronger than the consensus believed. That view was built around a few simple but powerful ideas. Easy comparisons after a three-year rolling recession, lean cost structures, pent-up demand, fiscal support from CapEx incentives and tax cuts, deregulation for the banks, and a monetary backdrop that was increasingly supportive through the liquidity channel.

1:01Mike Wilson:Putting those together, the setup looked like a classic early cycle. Revenue growth returning on top of lean cost structures leads to strong operating leverage and well above trend earnings growth. Fast forward to today, and that's exactly what's happened. The median stock in the S &P 1500 is now growing earnings at a double-digit pace, the fastest since the post-COVID boom. Revenue growth has returned, with the median stock growing its top line by 7%. That's a rolling recovery showing up where many investors still aren't looking. For much of this year, and particularly the past few months, most investors didn't want to hear that story.

1:40Mike Wilson:The Iran conflict pushed oil sharply higher. Rate-cut expectations turned into hike expectations. Faced with these headwinds, investors crowded back into the AI trade, especially semiconductors and memory in particular. To be clear, earnings revisions and semiconductors have been spectacular. The move wasn't irrational, but when something becomes the most owned, most loved, and most obvious area of the market, it becomes harder to surprise on the upside. That's where I think we are now. The hyperscalers have started to underperform, and that may be an early warning sign for semis, which are the key beneficiaries of the AI spending boom.

2:20Mike Wilson:Earnings revision breadth for semis is pressing against historical extremes. Again, this does not mean the AI cycle is over, but it does mean that the rate of change may be peaking, and when price momentum starts to fade in a crowded trade, it can lead to significant setbacks. It can also give other parts of the market room to breathe. In short, the broadening trade is back. The equal-weighted index and small caps are outperforming again. More importantly, the groups we have been recommending, consumer discretionary goods, transports, and regional banks, have already started to show relative strength over the past six weeks, even though positioning and sentiment remains neutral to negative.

3:02Mike Wilson:That's the kind of combination I like. Better price action, improving earnings, and investors still skeptical. One reason I've been more constructive on the consumer than others is that I've also been more bearish on oil. That view is not dependent on a grand deal between the U.S. and Iran, although that obviously helps. The signals were already there. The Brenta WTI spread narrowed, and energy stocks began underperforming from the day the conflict started. The market was telling us something before the headlines confirmed it. And longer term, I think the conflict has put the world on notice. This choke point around the Strait of Hormuz must be solved.

3:41Mike Wilson:It's no longer a risk that the world is willing to tolerate. New routes, new supply, and new energy strategies are likely coming. Necessity is the mother of invention, and I would not underestimate the world's ability to adapt. A less problematic oil backdrop helps the broadening trade too. So does the Fed, at least on rates. The June FOMC meeting told us two things. Forward guidance is going to be diminished, and the reaction function is now focused more squarely on inflation. My view is that falling energy prices, peaking tariff-related inflation, and contained services and housing inflation keep the Fed on hold rather than hiking this year.

4:23Mike Wilson:If that's right, lower-than-expected real rates could be a positive surprise for equities and another tailwind for the broadening of performance. The key variable to watch at this point is liquidity. This Fed is unlikely to be as proactive with balance sheet support. Just as the real economy needs more capital for CapEx and the markets are dealing with more equity in credit supply. That's the near-term real risk, especially for popular momentum trades. Bottom line, the market may look choppy and even weak at the index level over the next month, but the message underneath is improving. Earnings are broadening.

5:01Mike Wilson:Oil is falling. The shift is already underway with crowded momentum trades wobbling and the under-owned areas of the market starting to lead. Investors can either wait for it to become more certain or position before it becomes obvious and fully priced. Thanks for tuning in. I hope you found it informative and useful. Let us know what you think by leaving us a review. And if you find thoughts on the market worthwhile, tell a friend or colleague to try it out. The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice.

5:38It does not consider your financial circumstances and objectives and may not be suitable for you.