'Its recovery is fragile:' Morgan Stanley warns against chasing the market's rebound and explains why stocks are set to tumble again

Advertisement
'Its recovery is fragile:' Morgan Stanley warns against chasing the market's rebound and explains why stocks are set to tumble again

Advertisement
  • The stock market is staging a relief rally that should not be seen as part of a sustained move higher, according to Morgan Stanley Wealth Management.
  • Lisa Shalett, the firm's chief investment officer, laid out in a recent note three reasons why the S&P 500 is poised to retest its December lows.

If you think stocks bottomed out in December 2018, think again.

That's the message from Morgan Stanley Wealth Management is relaying to its clients and anyone who views the market's recovery as part of a sustained move higher.

According to chief investment officer Lisa Shalett, stocks are going through a relief rally after a jolting sell-off that was likely overdone. The S&P 500 has rebounded 6.3% year-to-date, buoyed by whiffs of positive news on China, trade, the Federal Reserve, and other topics that raise investors' heart rates. But Shalett expects a return to the December lows soon.

"While we are encouraged by recent market developments - the stabilization in volatility, a more realistic estimate of 2019 earnings growth and some progress on policy fronts from the Fed and trade - we are not ready to chase the US equity market rebound," she said in a recent note to clients.

Advertisement

"In our view, its recovery is fragile and vulnerable to negative earnings guidance, the resumption of Fed policy normalization and clumsy policy execution by China."

Shalett explained in further detail why she sees these three factors - earnings, the Fed, and China - as catalysts of the next leg lower.

Starting with earnings guidance, analysts have sharply downgraded their estimates for 2019 S&P 500 profits. They made the steepest cuts to expectations in four years for the first half of 2019, according to FactSet.

Key companies including Apple have warned that their sales are coming in lower than anticipated. If more companies confirm what Wall Street fears, expect investors to incorporate this information into stock prices, Shalett said.

Read more: GOLDMAN SACHS: Traders are making huge bets that earnings will be disastrous for these 10 stocks

Advertisement

Lower guidance is not the only earnings-related risk. The reports pouring in over the next few weeks will show the extent to which higher wages and input costs are biting into company margins.

Shalett further identified some sector-specific earnings risks. In tech, tariffs are disrupting supply chains. And in financials, the flattening yield curve is not a good sign for lenders' profitability.

The Federal Reserve has helped flatten the yield curve - the gap between short and long-term interest rates commonly viewed as a recession indicator - and Shalett sees its forthcoming decisions as the second big risk to stocks.

Unlike interest-rate traders who see no odds for a rate hike this year, Shalett thinks that labor-market tightness, higher wage growth, and stable oil prices will pressure the Fed to continue normalizing.

"The recent rebound in equities and tightening of credit spreads have helped to relieve overall financial conditions, again giving the Fed room to normalize," she said.

Advertisement

The third and final risk is of course China, which is propping up its economy with fiscal stimulus while being mired in a trade dispute with the US.

"Although we believe that stimulus will reignite the economy by the second quarter, the potential for missteps is great," Shalett said. "What's more, we don't rule out China policy shifts as a source of volatility in the coming months."

In all, these three factors don't augur well for a stock-market comeback. And a shaky stock market would suggest that the US economy is also approaching a turbulent patch even if economists forecast otherwise, according to Martin Gilbert, the co-CEO of Aberdeen Standard Investments which oversees $736 billion in assets.

"The stock markets are telling us one thing and the economists are telling us another," Gilbert said in an interview with Business Insider's Sara Silverstein at the World Economic Forum in Davos, Switzerland.

He added: "I think the markets are usually right, but it's probably a slowdown rather than a recession."

Advertisement

In these uncertain times, Morgan Stanley advises investors to beef up equity positions in emerging markets, Japan, and Europe, and fund this reallocation with gains from US stocks while their prices are rising.

{{}}