Morgan Stanley Warns Stocks Could Fall Another 20% or More

This top strategist thinks falling prices could eat into companies' profits.

A lot of investors were happy to wave goodbye to 2022, Wall Street's worst year since 2008. The S&P finished down 19.4%, while the tech-centered Nasdaq shed 33.1%. The blue-chip focused Dow Jones did better, losing just 8.8% across the year. 

Unfortunately, a number of senior investment bankers predict 2023 could bring more stock market woes. Most recently, Morgan Stanley Chief U.S. Equity Strategist & Chief Investment Officer, Michael Wilson, said he thought the S&P 500 could drop by another 22% in 2023.

Why Morgan Stanley warns stocks could fall more

Wilson wrote in a note this week that next year's losses could be more significant than many are expecting. According to Bloomberg, Wilson thinks a peak in inflation would be "very negative for profitability." He added, "The consensus could be right directionally, but wrong in terms of magnitude."

Some analysts think that when inflation peaks, the Federal Reserve will ease up on its aggressive rate hikes and the stock market will recover. But Wilson argues this is only part of the picture. He thinks falling prices would have a knock-on effect on company profits, and the subsequent drop in margins would outweigh any benefit from a change in the Fed's stance.

Wilson also alerted clients to the risk that companies would be caught "off guard" by a combination of falling demand and a catch up in supply. Supply chain issues, caused by a mix of COVID-19 lockdowns, labor shortages, and other factors, have contributed to price increases and had a negative impact on production. If the supply chain starts to recover at the same time as recession-induced drops in consumption levels, he thinks the stock market could fall further.

How to invest during a recession

It isn't easy to invest during a recession, and warnings from top investment bankers of further drops don't help. There's an understandable temptation to keep your money on the sidelines and wait for things to bottom out. The trouble is that it's almost impossible to time the market and Wilson's forecast of a 22% drop may or may not be accurate. 

At the same time, there's an argument that recessions can provide an opportunity to buy quality stocks at lower prices. But there are a few caveats to this. Firstly, you need to be prepared for the possibility that the value of your investments drop even further. Historically, the stock market has always rebounded, but without a crystal ball it's difficult to know when or what additional volatility might unfold first. 

Here are some ways to manage an uncertain year ahead.

Invest for the long term

Thinking long term is a crucial part of investing. There are no guarantees, but historically, buying assets you believe in and holding them for a decent amount of time is a proven way to build wealth. It's one thing to fine tune your portfolio, which we'll touch on below. But don't panic and change everything based on recession fears. Trust in your original research. If you bought quality assets you believe will perform well in the long term, you might decide to wait for the recession to pass.

Consider dollar-cost averaging

If you're nervous about investing a lump sum only for it to drop in the following months, you could try dollar-cost averaging. This involves investing a set amount with your brokerage at regular intervals, such as $500 on the first day of every month. It takes some of the emotion out of your stock buying and evens out some of the risk of volatility in a bear market. 

Diversify your portfolio

Another way to manage the risks is to diversify your portfolio. Look at your investments and consider whether you're comfortable with the level of risk you're taking. Might you want to increase the proportion of bonds you hold? In general, people who are approaching retirement will shift the balance of their portfolio toward bonds which carry less risk and pay a regular income. This becomes even more appealing during economic downturns.

Other investment options during a recession include real estate or precious metals such as gold. If a large proportion of your portfolio is in higher-risk equities, you might switch to some more recession-proof stocks. That said, as a long-term investor, you've likely already built a portfolio of stocks that will stand the test of time.

Make sure your emergency is in good shape

Finally, you'll need a solid emergency fund. If you lose your job or face another financial crisis, you don't want to be forced to sell your stocks to cover it. Particularly if their value has fallen. It's important to have enough cash in a savings account to tide you over for at least three to six months. Some financial advisors suggest socking away enough for a year given the high levels of uncertainty and inflation we're experiencing.

Don't panic

It's never easy to see the value of your portfolio drop dramatically, particularly if you're nearing retirement. However, recessions are part of economic cycles and even if the market drops another 20% or more, this too shall pass.