Among the leading Wall Street firms, Morgan Stanley has been perhaps the most persistently bearish about the stock market since the latter half of 2018. Indeed, the firm was ahead of the pack in anticipating a decline in corporate earnings during 2019. Now, just as the bulls are reveling in the market's rebound to new record highs this week, a report from Lisa Shalett, chief investment officer (CIO) at Morgan Stanley Wealth Management, warns about "the vulnerability of growth stocks" and the negative consequences that this may have for the market as a whole.
"One of the most durable characteristics of the 10-year bull market in stocks has been the leadership of growth-style stocks—and in particular, technology stocks. Growth stocks have benefited from both the scarcity of secular growth over the past decade and low real interest rates, which support higher valuation multiples for long-duration assets. Recently, a shift in leadership from growth to value style...may signal a broader market correction," the report observes. One way for investors to protect themselves, says Shalett, is to neutralize their growth-focused portfolios by adding to value-oriented active managers.
Several of her key points are summarized below and discussed in this story.
Vulnerabilities For Growth Stocks
- Growth-style valuations are stretched
- Similarities to 1999 just before Dotcom Bubble
- Earnings misses against rich valuations make a "dangerous mix"
- High ownership of growth stocks by hedge funds
- Real interest rates appear to be bottoming
- Growth stock betas near all-time highs
- Regulatory pressures building
Source: Morgan Stanley, The GIC Weekly, April 23, 2019.
Significance For Investors
Given that many major stock market indexes, such as the S&P 500, are weighted by market capitalization, this means that they "are skewed to growth stocks," particularly tech stocks. In this vein, Shalett cites the adage, "as goes tech, so goes the market."
"Some investors have chalked up the decade-long superiority of growth to value to a belief that certain category killers have established quasi-monopolies that are competitively unassailable and thus deserve outsized valuation," Shalett writes. While acknowledging that some growth stocks indeed fit this pattern, she asserts that the vast majority of them actually have been buoyed by the loose money policies pursued by the Federal Reserve in the wake of the 2008 financial crisis.
"It has been the central bank’s extraordinary accommodation through negative real interest rates and Quantitative Easing that has fueled the party and all its gifts of stellar performance of financial assets. Few asset classes have benefitted more from this largesse than US growth-style equities," Shalett asserts. She doubts that this "extraordinary accommodation" is likely to persist longer term.
Meanwhile, high stock valuations imply high expectations about future profit growth. The report warns: "A mature business cycle is creating headwinds for profits at a time when P/Es are already rich. What’s more, many of the past decade’s highfliers, overowned by hedge funds, have seen their market betas inflate, removing their defensive characteristics. They are likely to suffer should real rates back up on a recovery in economic growth."
Social media stocks may suffer the most from this trend. These companies have drawn political fire and rising regulation worldwide, which may constrain their future growth. Shalett says this may prompt investors to sell shares of these big "growth stock winners" and use the cash to buy the latest wave of IPOs.