Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, April 5th, at 11:30 a.m. in New York. So let's get after it.
After a long year, we finally appear to be on the cusp of reopening the economy and getting our lives back to normal. While living digitally has been an interesting experience, it's not a sustainable existence in my view. Human beings need real interaction with others to thrive. As a result, people are excited to re-engage, with many already pursuing normalcy where they can.
Financial markets are excited, too, with many stocks and other asset prices reflecting the inevitable reopening that is now at our doorstep. Stock markets are discounting machines - in fact, they represent one of the best leading indicators for economic activity and company performance that we track. It's the reason why technical analysis is so important to our investment strategy process. To ignore it would be foolish.
Over the past few weeks, the S&P 500 has continued to make new all-time highs. However, underneath the surface, there has been a shift in leadership that may be telling us something about the future in the real world. More specifically, both the Russell 2000 small cap index and the technology heavy Nasdaq have underperformed the S&P 500 by 6 percentage points. While this follows a period of strong outperformance when relative strength like this breaks down, I take notice. Furthermore, the cyclical parts of the equity market I've been recommending for over a year are starting to underperform, too. If that weren't enough, an index of recent IPOs and SPACs have underperformed by 20% and are now both down on the year.
So what are all these technical breakdowns telling us? In my view, the breakdown of small caps, the Nasdaq and cyclicals are potential early warning signs that the actual reopening of the economy will be more difficult than dreaming about it. All three of these areas have been stellar outperformers since the recovery began a year ago. In essence, they were discounting the recovery and reopening we are now about to experience. However, now we must actually do it, and that comes with execution risk. While policymakers have provided tremendous support for the economy with both monetary accommodation and fiscal stimulus, the lockdowns have reduced supply - some of which is permanent. As a result, we are now seeing evidence of supply shortages, in everything from materials, logistical support and labor. The punch line is that first quarter earnings season may disappoint on margins, particularly with respect to the second quarter outlook and guidance.
Meanwhile, the underperformance in IPOs and SPACs are a signal that the excess of liquidity provided by the Fed is finally being overwhelmed by supply. My experience is that when new issues underperform this much, it's generally not a good thing for equity markets more broadly.
From an investment perspective, we have made some changes to our recommendations in order to avoid these risks, while taking advantage of some new opportunities. First, we downgraded small caps three weeks ago. Second, last week we recommended investors upgrade their portfolios by adding higher quality stocks that have a better chance of managing through this reopening transition. More specifically, this would include stocks in the Consumer Staples, Healthcare and REITs sectors. It would also include reasonably priced large cap technology shares.
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