'Exuberant' Market Faces Second 10% Reversal Since January

While Morgan Stanley believes that "current U.S. economic fundamentals are strong," their Global Investment Committee issued this warning in the Oct. 8 edition of The GIC Weekly report: "When it comes to market and business cycles, too much of a good thing is often bad, as frothy activity levels counterintuitively pull forward a downturn and set up a more severe correction." Based on their concerns about "exuberant earnings expectations," the report leads off with the rhetorical question, "Peak Economy, Peak Earnings and/or Peak Markets?"

The standard definition of a stock market correction is a decline of at least 10%, while a bear market involves a drop of 20% or more. The table below presents the gains in several major U.S. stock indexes since the widely-accepted end of the last bear market nearly 10 years ago, at the close on March 9, 2009. (For more, see also: This Stock Correction Is Now the Longest in a Decade.)

Exuberant Stock Gains: 10 Years

Source: Yahoo Finance; computed through the close on Oct. 9.

Concerns for Investors

Morgan Stanley's report offers a variety of reasons why U.S. stocks may be due for a correction in the near future. Eight of them are summarized in the table below:

8 Reasons Stocks May Fall At Least 10%

Corporate earnings guidance has worst downward tilt since 2013
Corporate profit margins under increasing pressure
Rising interest rates should reduce valuation multiples
Latest data shows that the U.S. economy is peaking
Economic surprise indexes have rolled over
Credit growth is falling
Fiscal stimulus on track to peak by spring 2019
Key economic sectors are showing weakness

Source: Morgan Stanley, The GIC Weekly, Oct. 8 issue

The ratio between negative and positive corporate earnings guidance for the third quarter is running at an 8 to 1 ratio so far, the most negative reading since 2013. This raises the possibility that analysts' estimates for third-quarter profits may be too high on average, creating disappointments.

A combination of rising wages, oil prices, financing costs and tariffs are putting pressure on corporate profit margins. The rising U.S. dollar has crimped exports and means that profits earned overseas are being translated into fewer dollars. In the face of higher interest rates, valuation multiples on stocks are likely to sink.

U.S. GDP growth was a robust 4.2% in the second quarter, but the consensus among analysts is that this will drop to somewhere between 2.9% and 3.3% in the third quarter. Morgan Stanley expects it to be at the lower end of that range. They believe that strong readings on the Purchasing Managers' Index (PMI) are being driven by "inventory loading in anticipation of further trade tariffs" that will not be sustained.

Key sectors such as commercial real estate, residential housing, autos, semiconductors and exports are all showing weakness. As sectors that normally perform best early in an economic cycle, this suggests that the current expansion is now in its late stages.

Morgan Stanley sums up the U.S. economic situation this way: "While we don't see a recession in the next 12 months...we feel that 2018's scenario, in which the U.S. decouples from the rest of the world's slowing, is unsustainable. Reversion to the mean, coupled with pressure on the Fed to continue tightening, suggest growth has peaked for the cycle."

Looking Ahead

"Markets trade according to expectations and in anticipation of turning points, often topping out well in advance of a peak in economic activity," Morgan Stanley writes in their conclusion. They advise investors to watch earnings revisions, 2019 profit estimates and corporate guidance for signs of possible disappointments ahead. They also suggest trimming holdings of winners in tech and consumer discretionary stocks, while adding to defensive holdings in energy, industrials, consumer staples, telecom and utilities. With the new communication services sector, Morgan Stanley does not see a buying opportunity. (For more, see also: Wall Street Slaps Sell Rating On S&P's Newest Sector.)

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