With volatility at low levels this rally, investors shouldn't be surprised by a summer sell-off. Even so, the outlook long-term is still positive. Here's why.

Second-quarter earnings season is now in full swing, raising the question of what investors can expect from the rest of 2019 and into 2020. 

Investors worried about a summer selloff may want to trim their direct market exposure, but they shouldn't lose site of the long game.
Andrew Slimmon Head of Applied Equity Advisors Team, Investment Management

At first glance, two contradictions make for a puzzling read. First, although corporate profit growth is expected to be tepid this year, the S&P 500 index is up more than 20% year-to-date, closing above 3000 for the first time in mid-July. Second, investors are skittish about the prospect of slower economic growth, yet for the most part, markets have seen pretty low volatility.

In the face of such incongruities, it's important to stay focused on the big picture. Equities markets may still have room to run—but investors shouldn't be surprised by a summer sell-off. This is all consistent with long-term bull markets, which rarely follow a linear pattern. Instead, they follow a predictable (though admittedly frustrating) rhythm of rally, retest, recovery and repeat.

Here are four key points to factor into investment decisions heading into the later part of this year.

Equity Markets Are an Earnings Indicator

Markets aren't always rational, but history has shown that equity markets do a decent job of predicting earnings—as we’ve seen over the past year. The stock-market sell-off in at the end of 2018 predicted the earnings recession and economic slowdown this year, though in hindsight, it now seems exaggerated. By the same token, I believe the equity market rally in 2019 may be predicting an earnings recovery and economic improvement later in 2019, and into 2020.

Keep in mind that earnings recessions and recoveries are all relative. High double-digit earnings growth in 2018—thanks in part to the federal tax cut passed at the end of 2017—made for tough comparables going into 2019. As those comparisons roll off, however, it sets a more realistic bar for 2020.

My colleagues in the firm’s Global Investment Committee have nuanced views on how an earnings recession could spiral into an economic recession in 2020, but an earnings recession does not always mean an economic recession, as you can see in the chart below. That distinction is critical when thinking about the longer term prospects of this market cycle. 

Market corrections have historically preceded earnings recessions
without being associated with economic recessions

First Negative Quarter Last Negative Quarter Market Peak Date Market Trough Date Peak to Trough
Decline in S&P 500
Q2 1951 Q2 1952 6/12/1950 7/13/1950 -13.5%
Q1 1967 Q3 1967 2/9/1966 10/7/1966 -25.2%
Q1 1985 Q4 1986 11/29/1983 7/24/1984 -15.6%
Q1 1998 Q4 1998 7/17/1998 8/31/1998 -19.3%
Q1 2013 Q3 2013 5/1/2012 6/4/2012 -8.9%
Q2 2015 Q3 2016 5/19/2015 2/11/2016 -14.5%
Average: -16.2%
The -19.8% S&P 500 decline in Q4 2018 preceded the 2019 earnings recession
Source: St. Louis Fed, U.S. Bureau of Economic Analysis, Bloomberg; Past performance is no guide to future performance and the value of investments and income from them can fall as well as rise. Indices are unmanaged and not available for direct investment. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

This Market Still Has Room to Run

Continued strength in earnings—against the backdrop of easier comparables—is just one of the reasons to question the doom-and-gloom narrative that has kept some investors on the sidelines.

As I've pointed out before, bear markets are typically born out of excessive optimism, coupled with deteriorating economics. Yet investors are still sitting on the sidelines after cashing out of equity funds and ETFs late last year.

Other key factors also bode well for equities markets. The financial conditions index suggests that the U.S. economy is still very healthy, and, with the U.S. presidential election around the corner, the Trump administration will likely do everything it can to nudge the economy.

Although the U.S. Treasury bond yield between three-month and 10-year rates inverted earlier this year, it’s now back in positive territory. The initial inversion of the yield curve tends to precede market peaks by a full two years; historically, U.S. stocks have gained 40% on average during that period.

In another vote of confidence, companies continue to raise dividends, even in the face of lower rates. Notably, nearly half of the companies in the S&P 500 recently had a higher dividend yield than the 10-year Treasury.

A Short-Term Pullback Is Likely

At the same time, many investors have stayed on the sidelines of this year's rally. Evidence also shows that investors who are in the market may have grown a bit complacent. So far in 2019, the market has only experienced a decline of 1% or more in seven instances, vs. 32 times in 2018. Translation: The market may be overdue for some volatility.

Admittedly, trying to time short-term pullbacks within the context of a secular bull market is tricky. Still, given the lack of volatility and past patterns of pullbacks, now probably isn't the time to be turning up the volume on portfolio risk.

Investors worried about a summer selloff may want to trim their direct market exposure, but they shouldn't lose site of the long game. As we've seen throughout this cycle, selloffs have set the scene for further gains.

Keep in mind, too, that despite new highs for the S&P 500, the market was effectively flat for 350 days between January 2018 and June 2019. Since 1900, there have been just seven times when the market was effectively flat for 350 days. In all such instances, the market was up six months later.

Safety Stocks Have Been Overbought

As investors have gotten skittish this year, many have turned to consumer staples and other seemingly “safe" stocks. However, if there is any bubble in the market right now, it's in companies perceived as being recession-proof.

The quality growth spread—the valuation of the highest quality growth decile of the Russell 1000, relative to the market average—was recently two standard deviations higher than its baseline. Likewise the earnings stability spread was 1.5 standard deviations more expensive. Here is where you find the serious crowding. In a market pullback, overbought stocks pose the biggest risk.

Investors should neither think that high-quality growth stocks are the answer to market uncertainty, nor should they blindly rotate out of growth into value. Yes, value stocks have gotten increasingly cheap—and we think that investors have opportunities to select bargains.

Yet, ultimately, the best time to broadly buy value stocks is after a bona fide recession. True leadership change in the market never happens until after a bear market, and all indicators suggest that we just aren't there yet.

Adapted from the recent webcast “2019 Equity Market Update: Isn’t the Equity Market a Forward Predictor?" For more information, ask your Morgan Stanley representative or visit Morgan Stanley Investment Management. Plus, more Ideas from Morgan Stanley's thought leaders.

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