Market Watch: Morgan Stanley Sees Two Broken Legs for Stocks, Heralding Significant Market Correction

Article by Ryan Vlastelica on Market Watch

For years, one of the primary factors lifting the U.S. stock market has been the fact that some of the economy’s biggest, fastest-growing names just kept rising.

The strength of growth stocks, in particular some large technology and internet plays, has been a boon for momentum investors, who bet that recent outperformers will continue to do better than the overall market over the medium term. This trade has been one of the easiest ways for investors to make money, but analysts are increasingly concerned that its era may be drawing to a close.

Morgan Stanley called for “a breakdown in both legs of momentum,” which it warned “could be a trigger for a significant market correction.”

It’s “hard to walk with two broken legs,” it noted in a note to clients published earlier this week.

While recent price action has been positive, however, Morgan Stanley is concerned about how breadth — the number of stocks rising compared with the number falling — was diverging from price.

“Fewer stocks are carrying the load of the market, a sign of exhaustion and, in our view, a bad signal for further price gains,” the investment bank’s team of analysts wrote. It added that a recent example of a major stock hitting a notable milestone for strength — Apple Inc.’s market capitalization cresting $1 trillion — “sure sounds like a ‘ringing of the bell’ to us.” Rather than the $1 trillion valuation being a sign “that all is right with tech,” Morgan Stanley wrote, it “could be a meaningful historical market for a tradable top.”

Morgan Stanley has turned decidedly pessimistic about the U.S. stock market of late, anticipating a “rolling bear market” that hits different parts of the market at different times. Last week, it said the bull market could be in its “last innings” if bears went on to target areas of the market like small-capitalization stocks and the technology sector, both of which Morgan Stanley downgraded in early July. Recent signs of weakness in the market, it wrote, could result in the biggest market selloff in months.

While tech and internet stocks are the most visible “mo-mo” plays, Morgan Stanley said this trend was showing signs of deteriorating regardless of market sector.

Morgan Stanley is not the only firm sounding caution about momentum trends. According to July data from S&P Dow Jones Indices, the S&P 500 momentum index had outperformed the unadjusted S&P 500 by 15% on a total-return basis since the start of 2017. The firm wrote that this degree of outperformance “has rarely been exceeded historically and, when it has been exceeded, has tended to predict a subsequent period of weakness for the strategy.”

The last time the momentum factor saw such excess returns on an 18-month basis was in early 2008, as the financial crisis began to pick up steam. After peaking, momentum’s performance relative to the S&P 500 turned sharply lower, and didn’t bottom until mid-2010.

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