2 Big Red Flags For The Stock Market

Equity strategists at Morgan Stanley have issued a bearish outlook on the technology and consumer discretionary sectors. This has large implications, given that these sectors have been leading engines of economic growth and stock market gains. Also, while these sectors have been affected by a recent reclassification, Morgan Stanley writes: "The changes to the composition of Discretionary and Tech do not affect our negative bias on these cyclical sectors." (For more, see also: 5 Ways The S&P Stock Shuffle Will Affect Investors.)

Why Morgan Stanley Is Bearish On Techs, Consumer Discretionary

Source: Morgan Stanley U.S. Equity Strategy Warm-Up report, Oct. 1.

Concerns For Investors

Technology. Morgan Stanley gives a number of key reasons for the firm's bearish outlook. "We remain Underweight the revised Technology sector as we see underappreciated cyclicality to end markets and elevated relative valuations (particularly in Software) and positioning despite earnings growth relative to the market that has already decelerated considerably," Morgan Stanley writes. Valuation is another concern. Versus the full S&P 500 Index (SPX), the report finds that the sector's valuation is "very elevated relative to the market."

Specifically, tech now trades at an aggregate P/E ratio that is 7% higher than that for the S&P 500 as a whole. While this appears to be a low premium at first glance, it is more than 2 standard deviations above the sector's average relative valuation from 2010 onwards, which is a discount of about 4%. There also are large divergences within tech. In particular, software, which represents 50% the tech sector's market capitalization, is at a 40% valuation premium. Morgan Stanley sees "little upside" for software as a result.

At the other end of the spectrum, semiconductor stocks are trading at a 25% valuation discount versus the S&P 500. However, the report asserts, "Semis relative discount likely does not offer sufficient protection from the kind of earnings slowdown to which the industry is prone." The year-to-date (YTD) performance of the technology and consumer discretionary sectors, as currently constituted, are presented in the table below.

Techs and Consumer Stocks Have Been Hot

Source: S&P Dow Jones Indices, data through Oct. 1.

Consumer Discretionary. Morgan Stanley appears to be even more negative on this sector, the report says: "We continue to view Consumer Discretionary as an Underweight given it is an early cycle sector trading at peak valuations in a late cycle environment. After a strong run to start the year, we think the sector's valuations are failing to appropriately price in the risks of an end of cycle slowdown that is being discounted in other sectors."

Apart from ecommerce giant Amazon.com Inc. (AMZN), Morgan Stanley finds that "a broader slowdown in [revenue] growth and rising costs will likely challenge the earnings growth story on a sector wide basis more than is appreciated by the market." They note that Amazon represents 35% of the market cap of the sector, and thus its performance has an outsized influence on the aggregate results for consumer discretionary.

Specifically, valuation of consumer discretionary is "very elevated relative to the market," the report says. Since 2010, the aggregate P/E ratio of the sector has been, on average, roughly 15% higher than the P/E for the full S&P 500. Today that valuation premium is 35%, which is more than 2 standard deviations above the recent average.

Communications Services. Morgan Stanley also is cautious about the new sector communications services sector, which combined the old telecom sector with a variety of media-related stocks formerly in technology or consumer discretionary, most notably FAANG members Facebook Inc. (FB), Google parent Alphabet Inc. (GOOGL) and Netflix Inc. (NFLX). Morgan Stanley is unenthusiastic, having issued a lukewarm rating of equal weight. Overall, Morgan Stanley sees "earnings growth in line with the market."

Although the sector's valuation is about equal to that of the S&P 500 as a whole, and near its low from 2010 onwards (based on restatements of history in line with the new sector definitions), they do not see it as a "value sector." The report says, "we are reluctant to rely on history to find the right multiple for this sector."

Looking Ahead

Morgan Stanley's bearishness on the tech and consumer discretionary sectors is consistent with its overall negative outlook on U.S. stocks and other assets. They note that 2018 is, so far, the worst year for investors in a variety of asset classes since the financial crisis of 2008, and warn that rising interest rates are bound to drag down stock valuation multiples and prices. Nevertheless, it is possible that Morgan Stanley is unduly skeptical about the valuations of technology and communications services, as well as their prospects for continued growth. (For more, see also: Investors Face Worst Returns In 10 Years.)