The S&P 500 appears durable but a look under the surface shows it may be ripe for a 10% correction in the near-term, Morgan Stanley's stock chief says

• Morgan Stanley's stock chief reiterated his call for a 10% correction in the S&P 500 in a Monday note.
• Mike Wilson noted that over half of the companies in the index have seen drawdowns of over 10% since May.
• Wilson says these underperforming stocks will pull down the stronger stocks in the index in a "rolling correction."

The S&P 500's relentless rise in 2021 makes the benchmark index appear durable, but a look under the surface reveals that it may be time for a 10% correction.

That's according to Mike Wilson, Morgan Stanley's chief US equity strategist and chief investment officer. On Monday he reiterated his forecast for a 10% correction in the S&P 500, noting that "damage has been done" under the surface of the index that has climbed 18% year-to-date.

Wilson explained that while the broader S&P 500 has failed to correct more than 4% since March, 56% of the companies within the index have seen a drawdown greater than 10% since May 1. Sectors including energy, materials, discretionary, and financials have seen the greatest percentage of stocks with corrections over 10%, he noted.

Wilson expects that this weakness in the underperforming stocks will pull down the higher quality stocks in what he deems a "rolling correction," and eventually lead to the S&P 500 correcting 10%.

The stocks that end up leaders after the correction will depend on what exactly triggers the correction, he said. If the Fed's tapering plans and higher rates lead to a correction, the market may see a rotation back into cyclicals and re-opening plays as long-duration growth stocks take a hit. Meanwhile, if economic growth concerns lead to a correction, Morgan Stanley would favor defensive quality stocks.

Both of these scenarios appear equally likely to occur, said Wilson. In light of that, Morgan Stanley recommends investors adopt a barbell strategy of defensive quality stocks and financials.

The firm's year-end price target for the benchmark index is 4,000, a roughly 10% drop from current levels.