Despite a strong showing out of corporate earnings during the second quarter, Morgan Stanley is warning a correction is looming, pointing to earnings misses from market leaders like Netflix Inc. (NFLX) and Facebook Inc. (FB) as signs of what’s to come.
In a research note to clients, Morgan Stanley’s Mike Wilson, along with his team of equity strategists, said risks to the stock rally in July are mounting with it only expected to get worse given extended positioning and peaking growth rates.
Selling Has Just Started
“The selling has just begun and this correction will be the biggest since the one we experienced in February,” Morgan Stanley equity strategists wrote in the note covered by Bloomberg. They were referring to the middle of February when stocks fell into correction territory over fears of a red-hot economy and rising inflation. Stocks are considered to be in a correction when they decline 10% from a recent high. This time around it would be due to a realization that corporate earnings growth, while still strong, is starting to peak. “It could very well have a greater negative impact on the average portfolio if it’s centered on tech, consumer discretionary and small cap,” warned Morgan Stanley.
Based on the close of trading Monday, the Nasdaq Composite Index ended down 1.4%, bringing the total decline for three days to 3.8%. Meanwhile, Facebook fell 2.2%, while Alphabet’s Google (GOOG) closed down 1.5% and Netflix fell 5.7%. (See more: Facebook Plunge Hits Hedge Funds Hard.)
July Rally Showing Signs of ‘Exhaustion”
According to the investment bank, the rally is beginning to show signs of “exhaustion” with a lack of major positive news to move equities higher. The report pointed to Amazon.com Inc. (AMZN) as one positive catalyst that investors can no longer turn to. “With Amazon’s strong quarter out of the way, and a very strong 2Q GDP number on the tape, investors were finally faced with the proverbial question of ’what do I have to look forward to now?’ The selling started slowly, built steadily, and left the biggest winners of the year down the most,” wrote Morgan Stanley.
Morgan Stanley said the July rally was largely based on optimism about second-quarter earnings but shrugged off misses at some of the big name companies like Netflix and Facebook. That is worrying because the markets ability to ignore high profile earnings misses is giving investors a “false sense of security.” Wilson and his team said the market is going through a”rolling bear market” in which every sector in the S&P 500 goes through a “significant derating” except for tech and consumer discretionary stocks. Those two sectors have been the big contributors to the market rally this year with tech stocks up 12.5% and consumer discretionary stocks 12.8% higher, noted MarketWatch. “While it is possible tech and consumer discretionary stocks won’t experience the derating witnessed in other cyclical sectors, we think it is unlikely and are only emboldened by the misses from Facebook and Netflix. We recognize that money can also move from these sectors to others thereby leaving the S&P 500 around current levels rather than falling 10% as we expect.” (See more: Netflix Sell-Off Is Good for Bulls: Bernstein.)