MORGAN STANLEY: The stock market's rally to new highs is masking 3 under-the-radar warning signs that danger lies ahead
- Stocks have rallied to new highs as investors anticipate the interest-rate cut likely to come this week.
- According to Mike Wilson, the chief US equity strategist at Morgan Stanley, the S&P 500 rally is serving as a misleading indicator of the investing climate ahead.
- He singled out at least three trends beneath the surface that illustrate why there's more unease among investors than the S&P 500's current level is implying.
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A stock's price, on its own, is often not the best gauge of a company's worth or prospects.
One Wall Street strategist is applying this maxim to the broader market, arguing that the recent rally to all-time highs is painting an inaccurate picture about what the future holds.
The rally has been partly driven by investors' anticipation of the interest-rate cut that the Federal Reserve is expected to announce on Wednesday. Such a cut could be interpreted as a cue that turbulence lies ahead for investors. However, the market's rally to new highs since the Fed's so-called pivot shows that investors are foreseeing a conducive climate for corporate earnings growth.
The latter scenario is less convincing to Michael Wilson, the chief US equity strategist at Morgan Stanley.
"While that conclusion is usually the right one, there are times when the market index can be a bit misleading," Wilson said in a recent note to clients. "We think this is one of those times."
He pointed to three trends that indicate there's are more threats to the S&P 500's rally than meet the eye.
His first observation is that broader indexes like the Russell 2000 and Wilshire 5000 are underperforming the S&P 500. The benchmark index is also underperforming an alternative version in which all companies are weighted equally, not by market cap.
These performance gaps show that a larger swath of the market is pricing in slower growth ahead, Wilson said.
Some investors have expressed their concerns about slower growth by buying parts of the market they expect to outperform in a harsher environment. Wilson's second observation is that the quality factor - which includes companies with low debt and a high return on capital - is topping the performance charts.
"Rarely have we witnessed such a defensive skew in leadership, particularly with the S&P 500 making all-time highs," he said.
Finally, he observed that the same underlying defensive factors driving the stock market are at play in parts of the credit market. Leveraged loans are underperforming relative to an index of Treasuries that mature in seven to 10 years, Wilson said.
These trends are unfolding against a backdrop for corporate earnings that Wilson says is deteriorating. While the second-quarter reporting season is not over, he pointed out that the share of S&P 500 companies providing negative earnings guidance, relative to those offering positive guidance, has spiked to a three-year high.
Combine this with the enthusiasm for lower interest rates, and you have a stock-market rally that is ignoring fundamentals, according to Wilson.
He also flagged the systematic strategies that have fueled the rally by riding the price momentum higher. In his mind, their rules-based nature means that the market's eventual reversal could be sharper than investors expect.