• Morgan Stanley’s top strategist says stock gains at the start of November are just a bear market rally. 
• Further upside will be limited as market fundamentals have not improved. 
• “We think last week’s rally in stocks was mainly a function of the fall in back-end Treasury yields.”

Major stock indexes are coming off their strongest weekly performances of the year, but to Mike Wilson, Morgan Stanley’s top stock strategist, further upside is likely limited and the fresh gains to start November are merely a bear market rally. 

In a Monday note, Wilson said fundamental and technical drivers are still missing, and macro factors don’t look promising for equities. Instead, the market was simply reacting to the plunge in bond yields after the benchmark 10-year government bond hit the highest level since 2007. 

“We think last week’s rally in stocks was mainly a function of the fall in back-end Treasury yields,” wrote Wilson, who has held a downbeat view on stocks all year. “In our view, the drop in Treasury yields was more related to the lower than expected coupon issuance guidance and weaker economic data as opposed to the bullish interpretation (for equities) that the Fed is going to cut rates earlier next year in the absence of a labor cycle.”

The bond market has endured historic turmoil in recent months, and in October the 10-year Treasury yield eclipsed the closely watched threshold of 5%. The bank pointed out, too, that real 10-year yields reached 2.5%, the highest level since 2007, excluding 2008 when the financial crisis began. 

Morgan Stanley chalked up last week’s rate move to shifting sentiment that economic data is starting to soften, which should take some pressure off the Federal Reserve to keep up its fight against inflation. The Treasury’s announcement for longer-term securities issuance also came in lighter than anticipated, helping bonds at the longer-dated end of the yield curve rally after selling-off all through October. 

Meanwhile, over the last two months, the breadth for earnings revisions and performance have deteriorated, according to Wilson. 

In the third quarter, 70% of S&P industry groups have negative earnings revisions breadth, and estimates for the fourth quarter have come down about 4% since the start of the most recent earnings season. Until those factors reverse, Wilson said, “we find it difficult to get more excited about a year end rally at the index level.”

He added that the earnings recession for US companies is likely not yet over, despite calls that earnings growth troughed in the middle of this year. 

“Such an outcome suggests last week’s rally should fizzle out over the next week or two as it becomes clear the growth picture does not support either Fed cuts or a significant acceleration in EPS growth in the near term.”

DataTrek Research noted Monday that the S&P 500 could return to its July high of 4,589 if bond yields drop below 4%. Lower rates are a particularly key catalyst for stocks going into year-end, the firm said, given weaker fourth-quarter earnings outlooks. 

Meanwhile, in a more bullish forecast, Bank of America analysts wrote last week that their sell-side indicator is close to flashing a “buy” signal that suggests 16% upside for the S&P 500 next year.