- All major US indexes declined sharply on Monday and investors retreated back to defensive stocks and stay-at-home plays.
- In a recent note, Morgan Stanley’s US equities chief makes a case for defensive stocks based on a deterioration of market signals.
- He explains why we could be entering a more vulnerable time for S&P 500 and how to position.
- See more stories on Insider’s business page.
Markets were panicking yesterday as all major US major indexes declines.
The S&P 500 experienced its steepest decline since May, while the Dow Jones Industrial Average saw its largest daily drop so far this year.
Rising cases of the COVID-19 delta variant and further lockdown restrictions in several areas of Europe has caused investors to become less optimistic about the outlook for global economic growth.
Virus-sensitive asset groups, such as energy and travel stocks, were hit hardest as the path for the reopening no longer looked straight forward.
In a research note on July 19, Morgan Stanley’s US equities chief Michael Wilson recommended a return to stocks with defensive qualities based on a meaningful deceleration in earnings and economic growth.
“We think the quality rotation will now begin to favor more defensive properties like earnings stability rather than growth,” said Wilson, in the note.
For months Wilson, who predicted the last two market sell-offs, has been telling investors they are in the mid-cycle transition phase of a market cycle, an environment where equities trading gets choppy.
Wilson predicted, on May 10, flattish equity returns throughout the rest of the year with a 10% to 20% correction along the way.
Is yesterday’s decline the start of this correction?
Market signals deterioration
In the note, Wilson highlights several market signals which have already started to deteriorate. One is market breadth, the percentage of stocks rising each day or making new all time highs.
Market breadth has been deteriorating for months and is just one of the many signals that confirms investors are in a mid-cycle transition, Wilson said.
“It usually ends with a material (10-20%) index level correction,” Wilson said. “More specifically, we think it is foreshadowing a significant growth deceleration in earnings and the economy that may feel worse than most are expecting.”
Although market breadth has been deteriorating for months, it’s now at its weakest point, Wilson said.
“More specifically, there are more stocks making new 52-week lows than highs when looking at the broad universe of stocks in the US market,” Wilson said. “Further, the % of stocks trading above the 50 Day moving average is below 50% for the S&P 500 and it’s much worse for lower quality indices.”
In addition two other signals, the equal-weighted S&P 500 relative to the market-cap weighted S&P 500 and the ratio of to cyclicals to defensives, have also started to break down.
“Finally, while our ratio of cyclical to defensive stocks rolled over at about the same time, we called for the mid-cycle transition back in March, it completely broke down last week, signaling we may now be entering that more vulnerable time for the index – i.e. a much more defensive rotation,” Wilson said.
Wilson also monitors the price-to-earnings ratios (P/Es) of stocks. He expects that earnings will surprise to the upside but that valuations would offset positive earnings revisions.
In a mid-cycle environment, P/Es typically fall by 20%, Wilson said. However, so far P/Es have only fallen by 5% while forward earnings are up close to 20%.
“If our narrative and framework are correct, P/Es should start to fall sharply over the next few months, bringing the index closer to our year-end target of 3,900,” Wilson said.
In this scenario, Wilson expects quality stocks with defensive characteristics rather than growth to continue to lead. This means focusing on sectors such as healthcare, consumer staples, REITs, telecommunications and utilities rather than just technology.
Insider lists 10 stocks to buy from the firm’s “Fresh Money Buy List”, as featured in the research note, to play in this environment.
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