‘The pendulum swung too far this summer’: Morgan Stanley’s stock chief warns it’s time to take a risk-off approach to the market given the recent rally — and shares 3 trades to pile into instead

  • The S&P 500 has rallied 17% this year.
  • But Mike Wilson says the advance is due to end as momentum subsides and spending slows.
  • He likes “defensive growth stocks,” industrials, and energy stocks.

According to Morgan Stanley’s Mike Wilson, the stock market’s rally is likely to fizzle out quickly.

The bank’s CIO and chief US equity strategist cited both technical and fundamental reasons in a client note on Tuesday that the S&P 500’s 17% gain this year is likely to end soon.

Let’s start with the basics. While the market’s performance has been driven in part by an emerging soft-landing narrative as economic data has held up, Wilson believes the rally is also the result of a positive feedback loop in which investors become more optimistic about the economy as stocks perform well.

But, as Wilson warned, the market has probably risen too far, and it’s time to start hedging against potential downside soon.

“Late in the cycle, when the data is conflicting, sentiment can be influenced by stock prices more than usual,” he explained. “We believe the pendulum has swung too far this summer and that a risk-off attitude will prevail in September.”

Furthermore, market breadth — or the proportion of stocks participating in the rally — remains low. Comparing the equal-weight S&P 500 index to the market-cap-weighted index is one way to look at breadth. A few of the market’s largest stocks drive the latter’s performance, while all stocks drive the former’s performance equally.

When compared to the market-cap-weighted index, the equal-weighted index performs significantly worse.

The tech-heavy Nasdaq 100 index is also showing poor breadth, with a negative net number of advancing stocks.

Wilson also warned that the market is under threat from deteriorating fundamentals in addition to overextended technicals. He’s particularly concerned about “real” consumer spending growth — or growth that takes inflation into account — which he and Morgan Stanley economists believe will fall year on year in the fourth quarter of 2023.

Consumer spending, which is a major driver of earnings, has a significant impact on stock market performance. Consumer spending accounts for approximately two-thirds of the US economy.

“Many have argued that the economy has been strong this year and is not in any way weakened.” “However, if we exclude the extremely powerful government sector, that conclusion may be different,” he said.

“In fact, personal consumption expenditure (PCE) growth slowed significantly in the second quarter and appears to be weakening based on recent commentary from numerous retailers and the recent rise in delinquencies,” Wilson continued. “As a result, we can’t help but be skeptical that economic growth is picking up speed.” To that end, our economists now expect real PCE growth to be negative in the fourth quarter, with nominal PCE growth of only 1.3%.”

“Potentially softer September and October data is not priced into many stocks and expectations, in our opinion,” he added.

3 trades to make

Given his pessimistic outlook for the broader market, Wilson advised investors to focus on “defensive growth stocks,” as well as industrials and energy sector stocks.

He claims that all of these typically outperform in late-cycle environments, and that the industrials sector is only 25% cheaper than the rest of the S&P 500 25% of the time.

Exchange-traded funds are one way to gain exposure to these market segments. The Invesco Defensive Equity ETF (DEF), the Industrial Select Sector SPDR Fund (XLI), and the Vanguard Energy ETF (VDE) are three ETFs that provide relevant exposure.

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