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Why Bulls Betting on Perfect Market May Get Burned by Q1 Sell-Off

Investors who expect good economic news to boost stock prices further should, instead, brace for weak data that will trigger a major sell-off in the first quarter of 2020, according to a detailed report by Morgan Stanley. Meanwhile, the CBOE Volatility Index (VIX), widely seen as a stock market fear gauge, has spiked despite widespread expectations that the Federal Reserve will keep interest rates unchanged this week.

“We see a wager on imminent manufacturing and GDP growth rebound as risky given the continued and unanticipated weakness in the underlying data,” writes Lisa Shalett, chief investment officer (CIO) at Morgan Stanley Wealth Management. Regarding the growing divergence in 2019 between a soaring S&P 500 Index and the falling Purchasing Managers’ Index (PMI), she observes: “Historically, gaps this large–they occurred in 2011, 2012 and 2014–result in a stock market pullback.”

Key Takeaways

  • Stock prices are reflecting a rosy view of economic fundamentals.
  • Instead, Morgan Stanley sees deteriorating U.S. economic data.
  • The firm’s wealth unit expects a stock market sell-off in Q1 2020.

Significance For Investors

Shalett is skeptical of this bullish narrative. Instead, she sees strong evidence that the U.S. economy has peaked: “economic data has disappointed, sending the Citi Economic Surprise Index into a nosedive, and earnings revisions and breadth have remained negative.” In the labor market, she sees weakening hiring plans and reductions in hours worked, indicating that consumer spending also may have peaked. She also warns that impending cuts in R&D spending could offset productivity gains from other capital expenditures.

Mike Wilson, the chief investment officer (CIO) and head U.S. equity strategist at Morgan Stanley, generally agrees. He sees a stock market that is “detached from fundamentals,” instead propelled by massive infusions of liquidity from the Federal Reserve and other central banks. He also is concerned about an artificial 20-year low in volatility, created by the same flood of liquidity, that is unlikely to last amid weak fundamentals.

In morning trading on Dec. 10, the VIX rose as high as 16.90, or 48% above a recent intraday low on Nov. 26.

Looking Ahead

Among the more prominent bulls is Sam Stovall, chief investment strategist at CFRA Research. He sees the S&P 500 reaching 3,435 by the end of 2020, or 9.6% above the Dec. 10, 2019 open. Stovall says the key drivers will be strong earnings growth in 2020, a U.S.-China trade deal, historical trends related to presidential election years, cycles of easing by the Fed, and low dispersion of stock market gains among S&P sectors.

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