Red Flags Waving Amid Bull Market's Record Gains

As U.S. stocks continue to reach new highs, Morgan Stanley finds an increasing number of stress points that threaten to bring the bull market to an end. In particular, key sectors that previously fueled the market's rise are turning into laggards, including techs and small caps in the past month. Additionally, against a background of rising trade tensions, overseas money seeking a safe haven has been flooding into the U.S. stock market, creating a temporary prop that cannot last indefinitely. The same can be said for the repatriation of cash balances held overseas by U.S. corporations, in response to tax reform, much of which is flowing into share repurchases

"The presumption that U.S. equity markets are ignoring the negative impacts of trade tensions is false," Morgan Stanley's U.S. equity strategists write in their latest Weekly Warm Up report. They add, "the underlying message from the sector leadership is clear and it's not constructive for how active investors (smart money, not smart beta) are thinking about trade's ultimate impact on the U.S. economy or earnings."

Why Investors Should Be Concerned

Tech stocks have gone from market leaders to laggards.
Facebook Inc. ( FB) and Netflix Inc. ( NFLX) are down by nearly 20% since highs over the summer.
Some semiconductor stocks are down 20% or more, with a worsening outlook.
Small cap stocks are now underperforming the S&P 500 Index (SPX).
Defensive sectors are outperforming.

Source: Morgan Stanley

Investors began rotating towards defensive sectors in June, with the result that an increasing number of former market leaders, most notably information technology stocks, have turned into laggards. Small cap stocks, as measured by the Russell 2000 Index also have flipped towards underperforming the large cap S&P 500 in this time period. More recently than that, international stocks have outperformed the S&P 500 since Sept. 11, Morgan Stanley observes.

Defensive sectors have outperformed the broad S&P 500, up 7.8% on a total return basis from June through Sept. 21. These are health care (+13.8%), consumer staples (+12.5%), consumer discretionary (+10.9%), and the old telecom sector, as it was defined through Sept. 21 (+9.9%). By contrast, technology was up by only 5.8% during this period. Mounting concerns have "forced investors into areas of perceived safety," Morgan Stanley observes.

What's Ahead 

"Despite no catalyst for a significant move lower, we also do not see much upside from the S&P as valuation is near our Bull Case Target of 3000," Morgan Stanley writes. They add: "the fwd [forward] P/E on the S&P is now above our estimate of 'fair value,'" and "downside risk on valuation is more likely in the face of higher [interest] rates." In July, Morgan Stanley downgraded tech and small cap stocks, a call that they note has been justified by subsequent events. Describing the current situation, Morgan Stanley calls it "a rolling bear market [that] tends to strike individual assets and sectors at different time leaving the major index flat."

For global portfolios, they recommend a "tilt back towards international markets," favoring Europe and Japan over emerging markets. For U.S. portfolios, they favor value over growth, overweight in energy, industrials, financials and utilities, while underweight in technology and consumer discretionary.

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