The earnings recession is still coming, and it's going to be worse than anyone thinks, Morgan Stanley said in a new note to clients on Monday.

The firm sees a "meaningful" earnings recession this year, with earnings declining 16% by the end of the year before experiencing a "sharp rebound" in 2024.

"This out-of-consensus earnings path is supported by our models and our view that policy will become more accommodative in 2024, not 2023," Morgan Stanley chief investment officer Michael Wilson wrote. "It's also supported by our thesis that we are in the midst of several 'hotter but shorter' earnings cycles in the context of a broader secular bull market (a 'boom/bust/boom' regime)."

Wilson and his team still see the S&P 500 falling from its current levels, which is currently up nearly 20% from the October 2022 bottom. The belief is that the S&P 500 will fall to 3,900 by year-end, and the S&P 500 will produce earnings per share of $185. Morgan Stanley's 2023 S&P 500 earnings per share target, which was revised down from $195 today, is 17% below market consensus, according to the firm.

Morgan Stanley isn't alone in saying things are getting a little too rosy for stocks. Earnings for S&P 500 companies have declined compared to the same quarter last year for two straight quarters now, according to Factset. Analysis from Bespoke Investment Group shows investors haven't bet this heavily on a drop in the S&P 500 since 2007. And economists continue to warn that an economic slowdown is coming whether the Federal Reserve continues to hike interest rates or not.

All the while, stocks have surged, with the Nasdaq now up nearly 10% in the last month. The S&P 500 forward price-to-earnings ratio is now in the top 20% of historical levels dating back to the 1980s, per Morgan Stanley. And AI-focused names like Nvidia (NVDA), Marvell Technology (MRVL), and most recently MongoDB (MDB) have soared following bullish commentary on the prospect of AI in their business.

While not bearish on the overall technology, Morgan Stanley's equities team isn't buying a seat on the AI hype train to lead investors to new market highs in 2023.

"While there will undoubtedly be individual stocks that deliver accelerating growth from spending on AI this year, we do not think it will be enough to change the trajectory of the overall cyclical earnings trend in a meaningful way as top line decelerates and cost pressures remain sticky," Wilson wrote. "As a result, we are now firmly out of consensus on our earnings view."

"In fact, the only other times the spread between our earnings model and consensus has been this wide were August 2008 and late 2001, both risk off periods for equities."

Where to hide from the 'cyclical bear'

While Wilson and his team still see a broader secular bull market, they believe a cyclical bear market is coming. The bear market is coming for earnings as markets have too quickly overlooked the lagging impacts of the rising interest rate environment.

Morgan Stanley likens the surge in stocks throughout 2021 and then the subsequent collapse in 2022 to post-World War II when the economy also struggled, as it is now, to manage excess savings and keep prices down.

This will lead to the tactical correction in some of the stocks, and the narrowly driven S&P 500, that have once again been bid up in 2023, Morgan Stanley argues.

When that happens, the path will play out as follows: The Fed's policy will become more accommodative for growth, but that will come with interest rate cuts in 2024, not late 2023 as futures markets currently indicate could happen.

In that instance, Morgan Stanley likes "traditional defensive areas" like healthcare, consumer staples, and utilities.

"We prefer defensive positioning for the tough earnings environment that we expect to continue and look for sectors and industry groups with reliable track records of outperformance late in the cycle/during earnings recessions," Wilson wrote.

Josh is a reporter for Yahoo Finance.

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