"It's Time To Get Defensive": Morgan Stanley Downgrades Tech Stocks To Sell

Last weekend, when discussing why the trade war with China has now lapsed into what it called a "vicious cycle" that can only end with a market drop, Morgan Stanley wrote that it expects further fallout from trade wars, and warned that among the various ways traders can position for escalation, is to ease on exposure to the tech sector which it predicted "is vulnerable as a sector where pricing has been insensitive to trade risks so far."

Now, in the latest note from Morgan Stanley's Michael Wilson, the chief equity strategist starts off my comparing the market with the recent volatility in the weather, writing that "the summer moved into full swing this past week in the United States with one of the steamiest July 4th’s I can remember" and resulting in "popup thunderstorms that have been epic lately, dropping as much as five inches of rain in just ten minutes near my house on Tuesday afternoon."

This reminds me of how markets have traded so far this year – unannounced storms that do a lot of localized damage over a very short span but end almost as quickly as they arrive.

Extending the weather metaphor, Wilson then picks up on a trope he has been discussing all year, namely the idea of "rolling bear markets" in which one specific asset class is slammed even as the rest of the market remains surprisingly stable. For context he brings up the vol shock in early February and the sharp sell-off in Italian BTPs in May which "stand out as perhaps the best examples of what investors have had to deal with this year."

Amazingly, neither of these events led to a broader, more systemic de-risking of portfolios. Instead, prices reset quickly in the affected assets and investors simply moved to higher ground.

To Wilson, this kind of price action is very much in line with his outlook for 2018: "a year in which tighter financial conditions drain liquidity, leading to the weakest links getting hit first and hardest."

And while US financial conditions still remain relatively loose, largely thanks to a tech-led market which refuses to drop, nowhere is the recent tightening in financial conditions more evident than in China, where despite 3 RRR cuts in 2018, has seen conditions tighten significantly, and are now approaching levels last seen during the financial crisis and the aftermath of the Chinese devaluation of 2015.

Going back to the idea of a "rolling bear market", Wilson describes it as feeling "awful at times in specific places, but not everywhere at once."

Perhaps it’s easiest to see when comparing regions, sectors or specific stocks. In other words, the damage below the surface is much worse than if you simply look at the broad indices. However, the higher ground is getting scarcer, with few completely dry areas.

Meanwhile, as financial conditions get tighter, and recall that Quantitative Tightening is set to begin in earnest this quarter, as the Fed accelerates the shrinkage of its balance sheet from $30BN to $50BN and as central bank liquidity goes into reverse some time in the next 2-3 months for the first time since the crisis...

... Morgan Stanley warns that these rolling bear markets aren’t over until they touch every last corner, "with the highest-quality areas eventually taken out to the woodshed" such as what happened during the 2014-16 rolling bear market, when emerging markets, high yield, and commodities bore the brunt of the pain.

So what caused the last rolling bear market to end: "It wasn’t until a US recession got priced in during early 2016 and hit the S&P 500 and the vaunted tech stocks that the bear market ended" Wilson explains and adds that "that this time is no different."

We have been vocal this year, suggesting that a bear market began in December with a peak in valuations, followed by a peak in sentiment and positioning in January. We also said that it would be a very unsatisfying bear market – for the bears.

Next, picking up on last week's report, Morgan Stanley warns that the bastions of safety in 2018 have remained the old stalwarts of this post financial crisis bull market: "the S&P 500 at the regional level and growth stocks at the sector and stock level – most notably, US tech stocks." We commented on this last weekend when we showed that virtually all S&P gains in 2018 have been on the back of a handful of tech stocks.

More recently, as shown in the chart below, US small caps have dramatically outperformed large caps and have become the safe haven of choice over the S&P 500 as investors have viewed them as less vulnerable to rising trade tensions.

While to Morgan Stanley this makes sense intuitively, it is "skeptical that US-centric small cap companies would be immune to a major escalation in trade tensions, which would ultimately be a significant drag on the US economy, too."

And, as a result of a market which continues to ignore the potential spillover effects to asset classes that have been relatively isolated so far, Morgan Stanley unveils its first downgrade: small caps:

With the dramatic 800bp of outperformance in US small caps versus large caps over the past three months, we are  downgrading our view on US small caps today from overweight to equal-weight.

But it's not just small caps that Wilson thinks "will get wet" to borrow from the weather metaphor, and as a result he writes today that "we are downgrading our view on the US technology sector to underweight from equal-weight" i.e. "sell", for the following reason:

While we are not worried about an economic recession as the catalyst for underperformance in these market leaders like it was back in early 2016, we do think that 2Q earnings season will bring an inevitable acknowledgement from companies that trade tensions increase the risk to forward earnings estimates, even if managements don’t formally lower the bar. Throw in the fact that these stocks have rarely, if ever, been so over-loved and over-owned, and the risk of a proper rain storm in this zip code increases significantly.

And, as part of its call to get more defensive this summer as growth peaks, rates top, and the curve flattens, a point which Jeff Gundlach also touched on last Friday...

... Morgan Stanley is today also upgrading defensive sectors such as telecom services and consumer staples to equal-weight from underweight.

But before tech bulls rage at Morgan Stanley for spoiling the party, the bank adds a silver lining: any selloff in tech now should result in a more stable market in the fall:

Finally, while we have been out of consensus with our outlook, we are cognizant that global risk markets have absorbed a lot of bad news this year, not to mention meaningfully tighter financial conditions. We think that our rolling bear market narrative has captured this unusual dynamic quite well. If we are right about growth stocks finally getting wet, it may finally lead to more stable weather in the fall.

On the other hand, with tech serving as the key support pillar for the market for much of the past year, one which Bank of America recently said was largely due to tech stock buybacks... 

... if a real tech selloff were to kick in - one where corporations were unable to step in and repurchase their stocks - it is anyone's guess just where it will stop, which perhaps explains Wilson's skeptical conclusion which prevented him from ending his note on a sugary high: "let’s not get ahead of ourselves."


Let it Go TheSilentMajority Sun, 07/08/2018 - 18:58 Permalink

TheSilenMajority is right, Apple is almost more Chinese than American considering how it runs its business!

Both Apple and Amazon share an ugly truth and that is their strong ties to America's government has in many ways allowed them to create a persona or facade that far outshines reality. This allows each company in its own way to exploit us while masking the huge amount of income they pluck from our government on all levels. The article below explores how each of these companies feed at the tit of our government sucking in a slew of American tax dollars while displaying tactics that harm the society they claim to serve.

 http://Apple And Amazon Share An Ugly Truth - They Exploit Us! .html

In reply to by TheSilentMajority

Consuelo Sun, 07/08/2018 - 13:37 Permalink

Does this mean catered Whole Foods lunch buffets, bean-bag chairs, $150k average salaries and chatty liberal metrosexuals and their equally confused girl friends, $40/plate sushi dinners, etc., might be coming to an end...?

The (abject) Horror...!!!

Arnold Sun, 07/08/2018 - 13:47 Permalink

Huh. Wow.

"But while corporate buybacks may be fading into earnings, it is total buyback activity throughout the first half of 2018 that reveals a surprising picture. As shown in the most recent "Chart of the week" from BofA, which lays out first half sector flows, corporate clients’ buybacks were the largest buyers within Financials ($10.6bn), Tech ($10.5bn), Health Care ($6.5bn), Consumer Discretionary, and Industrials.

In fact, in a dramatic display of just who has been buying tech stocks, BofA reveals that "net buying of Tech in the 1H was entirely buyback-driven."


same2u Sun, 07/08/2018 - 13:50 Permalink

Heard this shit so many times...this market is going much higher, like it or not...Fed is in complete control, for now...

The real crisis is years down the road, probably when debt/GDP reaches 160% or higher...

MrNoItAll same2u Sun, 07/08/2018 - 14:04 Permalink

We'll never make it past 2020 without a major crash and burn. If we had unlimited energy, then maybe another few hundred thousand trillion$ in digital bucks *might* stretch things out a bit longer. But we don't. The world is resource constrained and populations are expanding exponentially. There's not much left to munch on in the proverbial petri dish. And we all know what that means.

In reply to by same2u

MrNoItAll Sun, 07/08/2018 - 13:54 Permalink

No weather metaphor for this global economy can do justice to the immanent destruction headed our way without the "calm before the storm" cliche.

MusicIsYou Sun, 07/08/2018 - 13:57 Permalink

Most tech stocks are in reality just crap. I mean seriously, regular people will be banned from owning lethal lazer weaponry, and other than that there really is not any other reasonable new tech on the horizon, and everybody knows what a smartphone does. And Social media like Facebook is not really that valuable because it is merely an echo chamber where people lie for likes, and it is dumbing people down as they mindlessly share links. And then there is the approaching energy crisis: in order to fuel technology booms cheap energy is required to launch tech booms, but oil and gas discoveries are declining. So in reality, the stock markets are mostly junk, which does not surprise me, because in reality the stock market is fundamentally a "Socialist" device, and socialist devices always fall apart.

PitBullsRule Sun, 07/08/2018 - 13:59 Permalink

So it rained where he is... and he changed his forecast.

Thats not a good sign.

Another sign is, its free advice, so you'll probably get what you paid for it.

Scipio Africanuz PitBullsRule Sun, 07/08/2018 - 15:55 Permalink

Your oxygen is free, does that make it less valuable? Nevertheless, I understand where you're coming from so I'll take this opportunity to share something with you. Any information I share with you, is valuable ONLY if it affects, influences, or aids your existence in a positive manner. In order to provide you undiluted information, I cannot have a personal stake in what you do with it!

In addition, in order for me to receive, digest, and interpret the information, it has to be in solitude, which means I have to be dedicated to first, acquiring the information, second, decipher it, third, disseminate it.

All these have to be done free, for you, expensive for me and yet, I'm not authorised, or permitted, to demand coin from you. My only compensation, is my most ardent desire that you be free, so you may live your life as you choose and perhaps, out of gratitude, seek the creative power that granted you the bounty that's existence.

Only the free, can know God!...

In reply to by PitBullsRule

zebra Sun, 07/08/2018 - 16:13 Permalink


Stock drop

Short sellers pile in

Low volume rally

Short squeeze

New all time high


Repeat all steps above


This has been going on since the inception of ZH. I really wonder who is the real sponsor of ZH, a true specialist that only focus on the bad news.



gm_general Sun, 07/08/2018 - 16:45 Permalink

"US small caps have dramatically outperformed large caps and have become the safe haven of choice over the S&P 500 as investors have viewed them as less vulnerable to rising trade tensions."

This is a perfect example of what kind of pea-brained dimwits are putting money in stocks. If there is a trade war, the theory is that the economy will be hurt by rising prices resulting in an economic downturn. If this is the case, what kind of companies are more vulnerable to being wiped out (not just dented) by such a down turn? SMALL ones. DUH. While every dumb person is bidding up the Russell, the tech stocks have routinely been pounded lately. It used to be NAS and his brother Russell (think the movie Twins) moved alike as high beta siblings. Not lately. When it hits the fan the 100+ P/E Russell will take the prize for biggest deflation.


rex-lacrymarum Mon, 07/09/2018 - 20:58 Permalink

"Overowned" is a completely meaningless term. Every stock that exists is owned by someone at all times. There are no "unowned" stocks floating about in the Wall Street aether somewhere. Sometimes this nonsense is truly nauseating.