Morgan Stanley says the odds of a 20% stock market correction will depend on how much 3rd-quarter earnings growth decelerates

• The odds of a 20% correction in the S&P 500 will depend on how much third-quarter earnings growth will decelerate, Morgan Stanley said.
• “We are gaining confidence in a sharper deceleration but the timing is more uncertain,” strategists said.
• The benchmark index has thus far corrected by 6% before staging a bit of a recent rebound.
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The odds of a correction of up to 20% in the S&P 500 will depend on how much third-quarter earnings growth decelerates or declines, Morgan Stanley said in a note this week.

“We are gaining confidence in a sharper deceleration but the timing is more uncertain,” strategists, led by Michael Wilson, wrote in a note to clients.

The downside scenario is a path the strategists in September dubbed “Ice,” which would occur if upward earnings revisions slow and higher-frequency macro datapoints deteriorate. The upside scenario they called “Fire,” is a more optimistic outlook that would occur if the Federal Reserve begins to pull back on accommodative policies as the US economy heats up.

The market embarked down the fire path following the Fed’s announcement that it will finally tighten monetary policy. Now, they are waiting for the timing and magnitude of Ice, which will determine when the mid-cycle transition will be over, they said.

“Our Fire and Ice thesis is playing out,” they said. “Decelerating growth is normal during the mid-cycle transition for both the economy and earnings. However, this time the deceleration in growth may be greater than normal.”

The S&P 500 has been volatile and choppy in recent weeks as it catches up to rotations and rolling corrections, the strategists said, adding that this was expected.

“The S&P 500’s more erratic behavior since the beginning of September has coincided with the Fed’s more aggressive pivot toward tapering of asset purchases,” they said. “While the average stock has already experienced a 10-20% correction this year, the S&P 500 has avoided it, at least so far.”

The S&P has seen a correction of about 6% from recent highs, the analysts noted.

“As of today, that de-rating is about halfway done based on prior mid-cycle transitions,” the strategists said. “Whether this correction is 10%, 20%, or already over will be determined by what happens to earnings revisions over the next few months.”