3 reasons why the stock market is vulnerable to a sharp sell-off, according to Morgan Stanley

• "We must acknowledge that the 'risk reward' of the US equity market has deteriorated materially and the market is ripe for a drawdown," said Morgan Stanley's Mike Wilson.
• The chief investment officer and chief US equity strategist laid out 3 catalysts that could spark a drawdown in the stock market in a Monday note to clients.
• The catalysts include the Georgia Senate run-off election, softer guidance than expected during fourth quarter earnings season, and some kind of intervention by regulators to quash the exuberance in cryptocurrencies.
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The stock market is vulnerable to a drawdown to begin in 2021 after a fierce performance last year, according to Morgan Stanley's chief investment officer, Mike Wilson.

Optimism is high in the market right now as investors can see the vaccine-led economic recovery in their front view, and a 2020 that closed at record highs in their rear view. While this optimism alone won't spark a sell-off, there's three catalysts that could lead to a drawdown, Wilson said in a Monday note to clients.

"Extreme optimism and/or high valuations are necessary but insufficient conditions for a meaningful equity market correction," Wilson said. "Nevertheless, we must acknowledge that the 'risk reward' of the US equity market has deteriorated materially and the market is ripe for a drawdown."

The first catalyst could be the two Georgia Senate run-off elections, taking place on Tuesday, Wilson said. The outcome of the races will determine which party takes control of the US Senate. If just one Republican wins, the GOP will have 51 votes in the Senate and the Congress will be split. While some investors say the market has largely priced in a Republican win, an unexpected outcome could rattle investor confidence.

Read more: A crypto CEO breaks down why he would not be surprised to see Bitcoin and Ethereum rise at least 100% in 2021 - and says the current sell-offs are a 'very natural and healthy thing'

Wilson also said softer guidance than expected during the fourth quarter earnings season could trigger a stock drawdown. While investors are confident in the economic recovery in 2021 and anticipate a return to normal for companies hit hardest by the pandemic, they may lose faith if major companies signal a later-than-expected recovery during the upcoming earnings season.

The third potential catalyst could be "some kind of intervention by regulators and or the Fed to quash the exuberance in crypto-currencies," said Wilson.

In December, the Financial Crimes Enforcement Network (FinCEN) proposed regulation that would require companies to collect the names and addresses of people if they make cryptocurrency transactions over $3,000. Bitcoin's sky-high price demonstrates exuberance hasn't been squashed just yet, but Wilson is watching for what further government intervention could mean for cryptocurrencies and the broader equity market.

Read more: 2 Wall Street strategists break down why they are bracing for more volatility if the Democrats sweep the Senate - and share what stocks to watch as the Georgia elections play out