Last Monday, Morgan Stanley made quite a splash with its contrarian call, when in the aftermath of a handful of poor tech results, most notably from Facebook which lost as much as $150BN in market cap due to slowing user growth, the bank's chief equity strategist Michael Wilson boldly predicted that "the selling has just begun and this correction will be biggest since the one we experienced in February."
Worse, Morgan Stanley cautioned that a liquidation in tech/growth "could very well have a greater negative impact on the average portfolio if it's centered on Tech, Consumer Discretionary and small caps" due to the disproportional ownership of this group of stocks by professional and retail investors, as well as due to their outsized contribution to overall market performance since the financial crisis.
In retrospect, Wilson may have inadvertently led to just the latest short squeeze for growth stocks, because as disenchanted longs rotated into tech shorts, the Nasdaq has since surged to new all time highs, largely thanks to AAPL crossing the $1 trillion market cap threshold.
So has the market's action since Morgan Stanley's controversial call dampened the bank's bearish sentiment? Not all at all, and in a note released today, Wilson doubled down on his short tech reco, writing that "we continue to stress our defensive rotation/Tech underperformance call."
But why continue to press the downside case when price action suggests that the upward momentum remains intact? In three words: "Market on Edge" - that's how Wilson describes the price action, which he believes could go either way from here, but he is sticking with his call for Tech underperformance - while conceding that he will watch price action closely - "as we think that rolling relative earnings revisions in some areas of Tech, continued defensive leadership, breadth/price divergences, and rolling PMIs."
Meanwhile, "a breakdown in both legs of momentum" augurs poorly for Tech, growth, momentum, and the market.
Taking a step back, Wilson explains the fundamental driver behind his recent bearish shift, which he says has been shaped by the idea that "the continued tightening of global liquidity, a peak rate of change on economic and earnings growth, and a continued rise in inflation would be a difficult combination for risk assets to handle without some pain."
Markets globally (LIBOR-OIS, VIX, EM equities and debt, BTP spreads, derating in equity sectors like Fins, Industrials, Homebuilders, Transports, etc.) have been flashing yellow lights at different times this year, something which we have dubbed a "rolling bear market." Different parts of the risk complex have been hit, but at different times, leading to overall modest returns as we are still in a strong growth environment.
Meanwhile, with most sectors having been hit at least once, US Tech and Discretionary equities have remained as the holdouts - with several notable exceptions - persistently holding or expanding their multiples over the last 12 months while risk assets globally repriced.
That persistence of performance seems out of place to us and creates an obvious potential pain point for markets. If we are right, and Tech gets its turn on the volatility roller coaster, its market weighting, crowded positioning and overweight in growth and momentum strategies mean the pain will likely spread beyond just the Tech sector.
But what about continued strong earnings?
Here Wilson notes that while he previously thought that earnings might be the catalyst for the tech trade to unwind, the message there has been mixed, with management saying little to nothing about tariff risks other than that:
- it is too early to see an impact,
- impacts are still not really known as the bigger tariff implementations are still ahead, or
- that tariffs will not be a problem as prices will be passed along or absorbed by increased efficiencies.
Wilson believes statements 1 and 2 are accurate, but is skeptical that statement 3 – price/cost absorption – will be as easy to carry out as is being represented. He also adds that regardless of what he believes, "it is clear the market has, for the most part, not treated tariff risks as a negative catalyst" at least not in the US: after all China's stocks are just a fraction away from 2018 lows, and already deep in a bear market.
At the same time, the message on fundamentals has been more mixed after Facebook and Netflix showed that strong earnings results "were not written in stone in the FAANG complex, and seemed to validate our thesis." However, what failed to materialize was contagion. This was helped by Amazon, which had a stellar quarter that surpassed even bullish expectations on profitability, but even here Morgan Stanley saw warning signs and notes that "the poor price follow through after such a strong print was a sign of exhaustion and stretched positioning, in line with our call that the upside drivers from here are not clear."
What about Apple? Here, not even Wilson can find anything to criticize, noting that ASPs rising and strong services growth gave us the world's first $1Tr company. Well, he did find something to criticize, pointing out that "while the message from Apple will be interpreted by many to mean that all is right with Tech, and that we should just pack it up and move on from our Tech underperformance call. However, we believe there is still more to the story and can't help but think that Apple hitting $1 Trillion could be a meaningful historical marker for a tradable top when we look back at this period."
As a result of the above skepticism, Wilson and Morgan Stanley double down on their call for further tech pain:
We are sticking with our underweight Tech call as we think that rolling relative earnings revisions in some areas of Tech, continued defensive leadership, breadth/price divergences, rolling PMIs, and a breakdown in both legs of momentum all augur poorly for Tech, growth, momentum, and the overall market.
To support his point, Wilson then lays out several recent observations in the sector, starting with:
Software/Services Relative Earnings Revisions Have Turned Lower.
While the Tech sector has continued to deliver solid results, the relative revisions have rolled over quite hard for the sector, led by Software & Services, which includes internet stocks like Facebook and Google but not Netflix and Amazon (Exhibit 1).
Defensive Leadership Is Continuing.
Defensive leadership has still been dominant in the market. Apple helped Tech lead last week but the defensive leadership trend we have been commenting on was on full display last week with REITs, Staples, Utilities, and Health Care leading the market (Exhibit 2). While Tech rebounded last week, it is being supported by fewer stocks.
Breadth Is Diverging From Price.
Tech/Growth breadth continued to deteriorate. Exhibit 3 shows the percent of Nasdaq numbers making new 52-week highs versus the Nasdaq composite price level. We know there are issues with comparing stationary to nonstationary series, but nevertheless we make two simple observations: 1) Since we started our defensive rotation call in June, the number of stocks making new highs has been in a clear downward channel with lower lows and lower highs and 2) the index price level has continued to press to near new highs. In other words, fewer and fewer stocks are carrying the burden of lifting the market, a sign of exhaustion and, in our view, a bad signal for further price gains.
The big misses in PMIs this week, which were among the worst in several years. July was only the 2nd time in the history of the ISM Services report (1997+) that Business Activity, New Orders, and Backlog Orders all dropped 5 or more points m/m. We have to go back to the print following 9-11 for the last such occurrence. We have been warning that Tech is more exposed to PMI weakness than what has been priced in and the substantial turn lower this month does not bode well for next month or the rest of the year as the comparisons get considerably more difficult.
Momentum - Hard to Walk With Two Broken Legs: Wilson saved his greatest concern for last. In it, he shows how a sector neutral index of 12-month long short momentum has been performing over the last year. Tech and other growth stocks have been persistent drivers of the long side of this index given their remarkably steady performance. This is the same concern as Nomura voiced two weeks ago when the bank warned that "the most important trade of the past decade is now reversing." "
What makes us cautious on this uptrend now are the drivers of the two recent moves lower. The first leg lower was defensives outperforming – the performance laggards and short leg of the index. The second leg down has been led by weakness in Tech and growth – the performance leaders and the long side of the index.
Given the exposure of both discretionary and quant investors to the momentum factor, Wilson thinks that lingering weakness here "could feed on itself and invite further rotations, which will not be good for price momentum leaders –i.e. Tech and other leading growth stocks exhibiting strong price momentum on a trailing 12-month basis – or the market, given these stocks' dominant weighting in the overall index."