Why The Stock Market's Sell-Off Has Only Begun: Morgan Stanley

While many investors expect, or at least hope, that stocks will rebound from their recent selloffs, Morgan Stanley has a pessimistic view, seeing yet more declines ahead. Their latest Weekly Warm-Up report asserts as much: "we don't think the correction is done yet. We think attempts to rebound were more [short-lived] than sustainable. Recent price declines in crowded Growth, Tech, and [Consumer] Discretionary have caused enough portfolio pain that we think most investors are playing with weak hands." The declines of major U.S. market indexes from their record highs in 2018 are presented in the table below.

Stocks May See More Sell-Offs

Source: Yahoo Finance; data as of the Oct. 22 close.

Significance For Investors

Morgan Stanley sees declining liquidity and rising concerns about peaking growth as factors that will inhibit further gains for the S&P 500, as well as a shift by investors into a more defensive mode. Moreover, the categories of stocks mentioned above—growth, technology and consumer discretionary—have started to underperform recently, and the report sees more underperformance ahead. Morgan Stanley projects that forward P/E ratios for technology and consumer discretionary will decline by 6% to 8%, to put their valuations more in line with the S&P 500 as a whole.

'We struggle to see any scenario that will be as supportive of risks assets and sentiment going forward," the report says, in the course of an extended analysis of the equity risk premium. Morgan Stanley calculates the equity risk premium (ERP) as the earnings yield on the S&P 500 minus the yield on the 10-Year U.S. Treasury Note. The earnings yield is the reciprocal of the forward P/E on the S&P 500.

'We struggle to see any scenario that will be as supportive of risks assets and sentiment going forward." —Morgan Stanley

"Our view has been that 300-325 [basis points] is a fair level of the ERP given the current level of rates and our views of the cycle," the report asserts. The ERP hit a low for this cycle of 275 on Jan. 26, and Morgan Stanley calculates that a value of 325 corresponds with a forward P/E of 16.0 on the S&P 500, and a value of 2,795 for the index. In morning trading on Oct. 23, the index dipped below 2,700, implying upside potential of no more than 3.5% from this point, per Morgan Stanley's analysis.

Looking Ahead

Should the yield on the 10-Year T-Note rise by another 25 basis points, Morgan Stanley's analysis calls for an ERP of 350, corresponding to 2,688 on the S&P 500, which would represent roughly no change from morning trading on Oct. 23. "Movement much above 350 begins to price in a material growth slowdown," they add. Since late July, Morgan Stanley has recommended a rotation from growth stocks to value stocks. They expect valuations of growth stocks to decline sharply in the face of rising interest rates, which will cause the present value of expected earnings far off in the future to plummet. By contrast, value stocks tend to offer higher dividend yields and free cash flow yields in the present, giving them shorter durations and thus less sensitivity to interest rate hikes, per Morgan Stanley.

By contrast, Goldman Sachs believes that growth stocks, particularly growth stocks that are increasing their returns on equity (ROE), are well-positioned to thrive in the face of a slowing economy and rising costs. Additionally, Goldman recommends stocks with strong balance sheets as able to shrug off interest rate increases. Moreover, Piper Jaffray sees opportunities for bargain hunters among beaten-down tech stocks, having set price targets on several that imply gains ranging from nearly 20% to more than 120%.

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