MORGAN STANLEY: The stock market just shifted by a magnitude that usually precedes recessions. Here's why it's an ominous sign once again.
- The stock market's recent rotation from growth to value stocks portends more losses for investors who had crowded the fastest earnings growers, according to Morgan Stanley.
- Michael Wilson, the firm's chief US equity strategiest, found that this was the biggest such rotation since the 2000 and 2008 recessions. He has reason to suspect that this episode portends another crisis.
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The market's sudden shift away from the best-performing stocks has eerie similarities to moments of crisis.
Beginning last week, investors fled stocks with the strongest earnings growth for those that were considered cheap.
Some strategists described it as merely a technical rotation because of the extent of crowding that was prevalent in growth stocks. But Michael Wilson, the chief US equity strategist of Morgan Stanley, suspects that it's a signal of more trouble ahead - and the beginning of a longer downtrend for growth stocks.
His hunches are based on similar occurrences before the two most recent recessions. The chart below, which he published in a recent note to clients, shows that momentum stocks had similarly large breakdowns on a five-day basis.
"Perhaps the market is finally worried about an actual recession approaching, in which case the highest-quality stocks would finally be vulnerable," Wilson said.
He described the status quo before this rotation as a "Goldilocks" scenario. The favored end of the momentum trade was comprised of stocks that promised bond-like protection and the strongest earnings growth. Meanwhile, the short-momentum trade was in companies that were cyclical in nature.
But with the breakdown of the momentum trade, investors are losing out on the best of both worlds - growth and quality.
This might just be the initial step in a longer downward spiral for growth stocks, and where a possible recession comes into the picture, according to Wilson.
S&P 500 earnings-per-share growth was flat for the first half of the year and Wilson says it's likely to turn negative in the third quarter. Earnings for small and mid-cap companies have slowed even more sharply this year.
A profits downturn could not only rein in Wall Street's forecasts for earnings growth, but imperil Main Street's contribution to the economy if companies respond by slowing hiring. The latter is a more material risk to an economy that has been upheld mainly by consumer spending.
"In our view, this is the single biggest risk to the economic expansion that is not discussed in the mainstream," Wilson said.
His views - including calls for an earnings recession - have certainly run against the grain for several months. Given his more cautious outlook, he has also been recommending that investors underweight growth stocks and overweight defensive stocks.
The Invesco Defensive Equity exchange-traded fund includes companies that potentially have stronger risk-return profiles in times of market turmoil.
"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," Wilson said.
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