Morgan Stanley
  • Wealth Management
  • May 20, 2019

5 Reasons Market Resilience May Not Last

Despite recovering from the trade-triggered early May swoon, stocks could face headwinds from new signs of slowing economic and earnings growth.

The famed investor George Soros has a market theory called “reflexivity” that was on full display last week. His idea posits that markets can quickly recover after a selloff because investors expect policymakers to respond to the downdraft with potential solutions.

Case in point: In the past 10 days, we saw markets swoon mainly due to a dramatic escalation in U.S.-China trade tensions. Last week, after an initially steep selloff, investors quickly resumed risk-taking, perhaps assuming the drop in markets globally would be sufficient to get trade negotiations back on track and coax the Federal Reserve into reducing interest rates, as a kind of insurance policy against a slowing economy.

I think investors should remain cautious, focusing on high-quality defensive sectors and choosing actively managed funds over index funds. Below are five reasons why reflexivity may not hold:

  • Geo-political tensions are multiplying. I still expect the U.S. and China to eventually reach a trade deal, but it may take a while. Meantime, there is potential for tensions to worsen in Iran, North Korea and Venezuela.

  • U.S. economy is showing more signs of slowing. April economic data included some worrisome harbingers of slowing growth. Industrial production shrank and business equipment investment pulled back. Particularly disappointing was the dip in retail sales. These numbers could reverse, but bear watching. Preliminary second quarter GDP estimates are now plummeting.

  • Earnings could continue to weaken. Due to rising costs, corporate profit margins are shrinking. While first quarter earnings beat low expectations and grew 1.5%, profit growth has slowed sharply in the past year and I believe there may be an earnings recession this year.

  • The Federal Reserve may not come to the rescue. If economic growth falters, the Fed could lower interest rates. But that scenario has been priced into futures markets already. As I wrote last week, the Fed may be reluctant to cut rates.

  • Valuations seem high. If markets were cheap and expectations low, the kind of mixed economic data and political risks we’re seeing now could still allow for a bullish view. But stocks aren’t cheap. The S&P 500 has a price-earnings ratio of 16.7, a historically high number. If consumer and business activity continue to slow, it will be difficult for stocks to avoid an earnings recession in the second quarter.

While it is encouraging to see the market prove resilient, I don’t think investors should chase the current bounce. Instead, keep an eye on economic readings and focus on defensive positions, such as high-quality, fairly priced funds and other investments. While reflexivity may be at work in markets now, it may be wishful thinking to believe that will be the case indefinitely.

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