Despite stock records, bears have ‘unfinished business’ with market, Morgan Stanley warns
The recent record levels in the U.S. stock market have punished those who expected equities to turn lower, but at least one prominent skeptic is standing by his call.
Michael Wilson, the chief U.S. equity strategist at Morgan Stanley, said that despite the recent records on Wall Street, there are ominous trends occurring under the surface of the major indexes. These cautious signals suggest there’s more potential for weakness than may be immediately apparent, given both the S&P 500 SPX, +0.03% and the Nasdaq Composite Index COMP, +0.15% closed at records on Monday.
“Over the past two months, the U.S. equity market has moved decidedly more defensive and value is showing more persistent performance versus growth,” he wrote in a note to clients. The move to defensive sectors and value strategies, along with “weak breath and underperformance in former tech leaders,” are examples of the market “speaking loudly” with a view that is getting overshadowed by the indexes’ recent gains.
“The message?” he asked rhetorically. “The market seems to be (rightly in our view) worried about growth slowing later this year and next. The causes of the slowdown are obvious — tough comparisons, Fed tightening, cost pressures mounting, and the risk of trade tensions turning more consequential.”
In late July, Wilson wrote that Wall Street’s rally was showing signs of “exhaustion” and warned that investors should expect the biggest selloff since February’s market correction, which the Dow DJIA, +0.06% only officially exited on Monday. Thus far in August, the Dow is up 2.5%, the S&P is up 2.9%, and the Nasdaq has risen 4.5%.
The investment bank forecast “a rolling bear market,” and noted that “every sector in the S&P 500 has gone through a significant derating” with the exception of tech and consumer discretionary stocks, along with small-capitalization shares. In a follow-up report, Wilson said the bull market — which is by one calculation the longest in history — was in its “last innings” as these final untouched segments of the market’s rally were likely to undergo a similar drop.
Wilson affirmed this view in his latest note, writing that “the bottom line is that we think the rolling bear market that began in January has unfinished business with U.S. growth and small-cap stocks the most vulnerable.”
While recent gains in stocks have been broad-based — of the 11 primary S&P 500 sectors, 10 are positive for the month of August — defensive groups have been notable gainers. The telecommunications sector is up 5.1% in the month, while health care is up 3.5%. So-called cyclical sectors, which tend to have a higher correlation to the pace of economic growth, have lagged. The materials sector is up less than 0.5%, while industrial shares are up 0.8%. Energy stocks are off nearly 3%.
A notable exception to the cyclical underperformance involves the FAANG stocks, or the quintet of major technology and internet stocks that have boosted the market for years. The tech sector is up 5.6% in the month, while consumer-discretionary names (which includes Amazon AMZN, +0.27% and NetflixNFLX, +1.07% ) are up 3.9%.
The gain in defensive sectors “has been even more dramatic than we envisioned at the time” of upgrading the strategy in June, Wilson wrote. “In fact, it’s been one of the most persistent and one sided defensive rotations we can remember outside of a true growth scare.”
As this chart shows, the spread between cyclical and defensive stocks has dropped significantly in recent weeks.
To have the S&P 500 hit records at a time when defensive sectors are among the biggest gainers “is a rare combination in our experience,” Wilson wrote. “We have to respect the persistent strength of the U.S. stock market indices but think investors should continue to have more of a defensive and value tilt in their portfolios.”
There are “definitely times when a good defense is required to win the game. We think one of those times is now for investors.”