As the stock market recovers from its recent pullback, many investors are breathing a sigh of relief and some market pundits are forecasting more gains ahead. However, Morgan Stanley's U.S. equity strategy team sees major risks ahead for the market as a whole, and for three key sectors in particular. "We continue to believe we are in the midst of a rolling bear market across all global risk assets caused by a drain in liquidity and peaking growth," they write in their latest Weekly Warm-Up report. "Until last week, [Consumer] Discretionary, Growth, and Tech had been among the last holdouts...but we do not think the pain is over for Growth, [Consumer] Discretionary, and Tech," the report continues. The table below shows the percentage declines in the next 12-month (NTM) forward P/E ratios for the 11 S&P 500 market sectors, plus the Russell 1000 Growth Index, from Dec. 28, 2017 to Oct. 11, 2018.

Growth, Discretionary, and Tech Have Room to Fall Farther

Sector *NTM P/E % Change
Health Care (6.9%)
Tech (7.7%)
Utilities (8.2%)
Consumer Discretionary (8.6%)
Russell 1000 Growth (9.5%)
Real Estate (10.3%)
Consumer Staples (13.5%)
Communication Services (19.8%)
Industrials (20.1%)
Financials (23.2%)
Materials (23.7%)
Energy (38.7%)

Source: Morgan Stanley; *Sector P/E Change from December 2017 to October 2018

Significance For Investors

As the result of rising interest rates, Morgan Stanley believes that a forward P/E ratio of 16 times NTM earnings is now the ceiling for the S&P 500 as a whole, based on the assumption that rates will stay in a range of 3.00% to 3.25%. In February, they observe, a valuation multiple of 16 was the floor, given that rates were lower. The brokerage also expects volatility to increase.

As the table above indicates, "Growth, Discretionary, and Tech remain among the groups least impacted by the [market-wide] derating this year," Morgan Stanley notes. They note that the S&P 500 reached a valuation peak on Dec. 18, 2017, the day before the tax bill was signed. Additionally, a major risk for the market as a whole right now is severe downward pressure on profit margins, from a variety of macro forces that are pushing costs up and threatening to send demand down. Morgan Stanley discussed these pressures in another detailed report.

"We do not think the pain is over for Growth, Discretionary, and Tech." - Morgan Stanley

Among the industry groups that Morgan Stanley sees as having a high risk of margin compression due to cost pressures, possible peaking demand, or both, are autos & components, consumer durables & apparel, and retailing. All these are within consumer discretionary, per Fidelity Investments. Additionally, Morgan believes that the risk of earnings disappointments are high in retailing and consumer durables & apparel .Consensus estimates, however, foresee margin expansion in every sector of the market, MS notes. They find this to be overly optimistic, the result of "sanguine company guidance on topline growth and the ability to pass on costs." In fact, Morgan Stanley found several industry groups with high risk of profit margin compression, but which enjoy optimistic valuations or earnings estimates. "Transports, Tech Hardware, Consumer Durables, Consumer Services, and Retailing appear more exposed," they conclude.

Looking Ahead

The outlook for consumer discretionary depends heavily on continued economic expansion, employment growth, and wage growth. Within tech, the tech hardware & equipment sector is potentially at risk from demand that may be peaking, while both it and the semiconductor industry have moderate to high risk from margin compression, according to Morgan Stanley's analysis. Finally, against a background of rising interest rates, spurred by the Federal Reserve's commitment to keep inflation in check, and its decision to reduce its massive balance sheet, all market sectors face headwinds related to financing costs and equity valuations.