The market’s leaders have gone missing or have floundered this earnings season which is a worrying sign that the rally in stocks may be over.
More than 85% of S&P 500 members have beat analyst estimates. However, the pro-cyclical companies that investors expect to soar amid earnings have been falling behind. The biggest winners of the year so far aren’t even posting gains as damaging earnings misses have sent both Netflix (NASDAQ: NFLX) and Facebook (NASDAQ: FB) shares crashing.
Morgan Stanley (NYSE: MS) believes that the dramatic drops in these high-fliers is a warning sign for stocks as the two tech giants may be bellwethers for what’s on the horizon for the broader market.
“The weaker earnings beat from several Tech leaders and outright misses from Netflix and Facebook were simply additional support for our [defensive] call,” said Michael Wilson, chief U.S. equity strategist at Morgan Stanley, in a note to clients Monday.
Wilson and analysts at the bank said that the rally in stocks is showing signs of “exhaustion,” and that with major catalysts for trading now behind us, there’s not much that could continue to push stocks higher.
“With Amazon’s strong quarter out of the way, and a very strong 2Q GDP number on the tape, investors were finally faced with the proverbial question of ‘what do I have to look forward to now?’ The selling started slowly, built steadily, and left the biggest winners of the year down the most. The bottom line for us is that we think the selling has just begun and this correction will be the biggest since the one we experienced in February,” Morgan Stanley analysts wrote in a note to clients.
After its highs in late-January, the S&P 500 fell more than 10% through early February as investors reacted to a stronger-than-expected jobs report and wage growth number, which ignited concerns over interest rates rising in the future.
Currently, the market is down 1.5% from its monthly high. Wilson reiterated his 12-month target for the S&P 500 of 2,750 – representing 2.8% downside from Thursday’s close.
Morgan Stanley believes that the overall good performance of tech stocks over the last year has left investors unprepared for this imminent correction, and it’s likely the average investor could suffer even more this time around.
“It could very well have a greater negative impact on the average portfolio if it’s centered on Tech, Discretionary and small caps, as we expect,” the note said.
Wilson also pointed out that the relative valuation between growth and value stocks has historically only been higher than it is now during the dot-com bubble, and noted that the 10-year return disparity between the Russell 1000 Growth index and the Russell 1000 Value index is at its 96th percentile since e1980.
“Large Cap Growth stocks have outperformed US Large Cap Value stocks by an almost unprecedented amount over both the recent past and prior decade,” Wilson said. “Fighting momentum is a difficult game but when you time it right, it can be very profitable. We think one of those times is now for Growth shifting to Value.”
Morgan Stanley wrote that “we are experiencing a rolling bear market,” and Wilson is now overweigh utilities, energy, industrials, and financials, which he said should outperform in a shakier environment.