Morgan Stanley: Despite Recent Earnings Downgrades, Shares Offer Bullish Upside

Morgan Stanley (NYSE:MS) reports Q1 results on Apr. 14. For the past 7 quarters, the global financial services player has beaten EPS expectations. However, over the past 3 months, there have been evidence that stocks with negative skewness tend to outperform those with positive skewness.

To make it easier to directly compare the probabilities of positive and negative returns, I rotate the negative return side of the distribution around the vertical axis (see chart below).

Source: Author’s calculations using options quotes from E-Trade

This view shows that the probability of positive returns are consistently higher than the probabilities of negative returns across a wide range of the most probable outcomes (the solid blue line is above the dashed red line on the left half of the chart above). The probabilities of large-magnitude losses are higher than for those of large-magnitude gains, but the overall probabilities of these outcomes is low. This is a bullish outlook for MS for the next 2.2 months.

Theory suggests that the market-implied outlook is expected to have a negative bias because risk-averse investors tend to overpay for downside protection (put options). While this bias cannot be directly measured, the potential for this effect makes the market-implied outlook for the next 2.2 months look even more bullish.

The market-implied outlook for the 9.3-month period until Jan. 20, 2023 has closely matching probabilities of positive and negative returns (the solid blue line and the dashed red line are very close to one another. Because of the expected negative bias, this type of market-implied outlook is interpreted to be slightly bullish. The expected volatility calculated from this distribution is 34%.

Source: Author’s calculations using options quotes from E-Trade

The market-implied outlook for MS to the middle of June is bullish and the outlook to early 2023 is slightly bullish. The expected volatility is quite stable at 36% to mid-2022 and 34% to early 2023.

Summary/h2

Morgan Stanley is currently more than 20% below its 12-month high close from early February. Although rising interest rates tend to be a tailwind for banks, faltering equity markets will have a disproportionate impact on its earnings compared to peers.

The Wall Street consensus outlook remains bullish and the consensus 12-month price target implies a total return of 28-29%. So, from this perspective, the shares appear to have been oversold on earnings fears.

As a rule of thumb for a buy rating, I want to see an expected total return that is at least half the expected volatility (about 35% in the market-implied outlooks) and MS looks attractive on this basis, even with a significant discounting of the analyst outlook.

The market-implied outlook to the middle of June is bullish, and the outlook to January of 2023 is slightly bullish, so I am maintaining my bullish rating.