The current bull market has been led by growth stocks, but a major shift in the markets may be underway. In a recent report, Morgan Stanley's U.S. equity strategy team led by Michael Wilson says, "The decade-long run of Growth versus Value may finally be at risk of turning on a more sustainable basis." They add, "We also see further relative downside ahead for small caps and high multiple growth cyclicals like Tech and [Consumer] Discretionary. With S&P 500 upside capped on a valuation basis, it's more likely that Value outperforms by going down less or simply not going down." Key recommendations in this report are summarized in the table below.
A Seismic Shift In Strategy: Growth To Value
|What to Sell||What to Buy|
|Growth Stocks||Value Stocks|
|Small Caps||Large Caps|
|Cyclical Stocks||Defensive Stocks|
Source: Morgan Stanley, "Weekly Warm Up: The Tipping Point," Oct. 8
Significance for Investors
Morgan Stanley already has issued sell signals on tech and consumer discretionary, based on peak valuations and slowing earnings growth. They are cautious about the new communication services sector, which includes internet and gaming stocks, among others. Meanwhile, they see that "valuations today are much more varied across sectors and styles than they were in January when almost everything was rich." (For more, see also: 2 Big Red Flags For The Stock Market.)
Rising real interest rates and decelerating U.S. economic growth are the underlying forces behind Morgan Stanley's belief that the market is at a "tipping point." They have been recommending a swap from growth to value stocks since July, and they believe that hit taken by growth stocks last week confirmed their assessment. However, they add that "Our call for a rotation was driven more by our aversion to Growth stocks than a real penchant for Value. Value looked reasonable while Growth looked expensive."
Nonetheless, they also observe that "highly valued growth stocks that pay no dividends are the longest duration assets in the world." Most of their worth is concentrated in expectations of earnings far off in the future that are discounted to the present day. As interest rates rise, the present value of far-off earnings shrinks significantly.
In July, Morgan Stanley also downgraded small caps, given that they are highly cyclical, and less able to pass along rising costs or "mitigate falling demand" than large caps. By contrast, "typically large caps offer better defensiveness than small caps."
Looking at last week's trading, the report observed: "The worst performers were a mix of early cycle and high growth/multiple sectors: [Consumer] Discretionary, Tech, and Internet and Gaming within Comm[unication] Services. Real estate rounded out the list of the bottom 4, performing sectors, but this was less about derating [that is, lowered valuations] and more about rising rates and slower growth. In contrast, Energy (rising oil prices), Utilities (defensive), Financials (rising rates and a steepening curve), and Industrials (earnings revisions and a multiple that has already derated) led."
What Morgan Stanley views as a seismic shift in the stock market may take time to unfold, if indeed they are correct in spotting a new trend. Moreover, the same firm sees various signs that a stock market correction is likely in the near future. Whether the various portfolio rotations that they recommend will offer adequate protection to investors is an open question. (For more, see also: 'Exuberant' Market Faces Second 10% Reversal Since January.)