The S&P 500 Index (SPX) has rocketed upward by more than four-fold since the last bear market hit its bottom in intra day trading in March 2009. Much of that advance has been led by momentum stocks, or stocks that investors have been bidding upwards precisely because they already were rising, thereby creating a self-reinforcing trend. Now, Morgan Stanley says these momentum stocks are stalling, which the firm says is an ominous warning sign of both a recession and major stock market declines ahead.

"The last two times we've experienced a momentum breakdown this severe, it preceded or coincided with an economic recession," warns the U.S. equity strategy team at Morgan Stanley headed by Mike Wilson. "We do not view this recent breakdown in momentum to be a positive signal for the broader market or economy as some are suggesting," they add, in the current edition of their Weekly Warm Up report.

Morgan Stanley's report comes as the Federal Reserve is expected to lower interest rates on Wednesday, amid heated debate over whether rate cuts can revive the slowing U.S. economy.

Key Takeaways

  • Momentum stocks are undergoing a major breakdown in performance.
  • Morgan Stanley sees problems ahead for the economy and for stocks.
  • Secular growth stocks are highly vulnerable.
  • Even good news on trade may not be enough to buoy the market now.
  • Goldman Sachs, however, has a generally bullish outlook, despite risks.

Significance For Investors

The reason why momentum stocks are sputtering, Morgan Stanley says, is that investors are anticipating the end of the so-called Goldilocks economy, in which growth is "just right," neither too fast nor too slow. Perhaps more important, the firm says that the current breakdown in momentum is much more severe than in the last two episodes when fears about declining economic growth were rampant, in 2015-16 and in 4Q 2018.

"We continue to think secular growth stocks remain the most vulnerable part of the market and the recent breakdown in momentum suggests that risk is even greater today than it was at the last market high in July," the report says. "The big winners this year are likely to come under further pressure," it adds.

Morgan Stanley also cites the breakdown in S&P 500/Gold Ratio and the IPO Index relative to the S&P 500 as more signals of risk aversion. "These breakdowns are just another reason to believe this month's rally will fade, with the most downside coming from the most speculative part of the market--i.e. growth stocks that have valuations that are hard to justify on traditional metrics," according to the report. 

While some investors are betting that the U.S. and China finally will reach a trade deal, Morgan Stanley sees no resolution in sight. Worse yet, they doubt that trade can be a "positive catalyst" at this juncture. Also, if the effective dates for new U.S. tariffs on Chinese goods are delayed, the report speculates that companies may cut back on orders, since they no longer would feel an urgency to meet an artificial deadline beyond which prices will rise.

Looking Ahead

Morgan Stanley cautions that the breakdown in momentum stocks, and the heightened vulnerability of secular growth stocks, may not initiate a smooth rotation to value stocks. The problem is that active investment managers are so heavily weighted toward growth stocks that "such a rotation will create too much portfolio destruction."

Goldman Sachs, for its part, remains cautiously optimistic even as it sees downside risk in its latest US Equity Views report: "Today, our SI [Sentiment Indicator] shows that aggregate equity positioning is 1.2 standard deviations above average, indicating that positioning poses a downside risk to S&P 500 returns in the near future." But that may not be the case right now, says Goldman, adding, "Accelerating [economic] growth has also generally offset the headwinds to stock prices from stretched positioning during the past 10 years." Goldman, thus, is forecasting "a modest reacceleration in economic growth...[which] should support equity prices despite stretched positioning."