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, September 13th, at 11:30 a.m. in New York. So let's get after it.
As we enter the last third of the year, markets continue to send mixed signals on the economy and growth. For example, while the S&P 500 and Nasdaq are close to all-time highs, the Russell 2000 small cap index and many individual stocks are well off their highs. In fact, since May 1st, 90% of all stocks in the Russell 2000 have experienced a 10% drawdown, while 55% have fallen by more than 20%. For active equity fund managers, catching the rotations under the surface this year has been more important than simply calling the index. As we have suggested, this is what typically happens during the mid-cycle transition in any economic recovery from a recession.
We were very bullish on the cyclicals and small caps as we entered the year, expecting interest rates to move sharply higher as growth accelerated towards its peak rate of change in the recovery. However, in March, we pivoted towards quality and downgraded early cycle sectors and small caps. This worked out very well, but now we find ourselves wondering if the growth deceleration has been effectively priced at this point. In addition to the rolling correction in the average stock, riskier assets like Chinese equities, commodities and cryptocurrencies have experienced 20-50% drawdowns with high volatility.
Meanwhile, risk free assets have traded very well since the mid-cycle transition began. Perhaps no market illustrates this flight to quality better than 10-year Treasuries. 10-year yields peaked at 1.75% before trading all the way back to 1.1% in early August. Since then, these yields have risen, but they are struggling to reclaim their 200 day moving average, which currently sits at 1.35% and is falling. In short, the Treasury market is trading as if the growth slowdown we have been expecting gets worse before it gets better.
While our economics team recently cut their third quarter U.S. GDP forecast from 6.5% to 3.4%, they believe growth will rebound in the fourth quarter. While that may be true, I'm not as optimistic about earnings revisions. While economic growth is obviously an important input to earnings growth, they don't always sync up. Recall last year when the economy was struggling from the lockdowns. Earnings revisions were bottoming and turning up as soon as the second quarter. We think it's the opposite now. Due to the extraordinary stimulus checks that went out in the first quarter of this year, many companies have been over earning, and that led to earnings revisions that are no longer sustainable. We suspect they are more likely to head lower from here, which typically has a negative impact on the stocks, especially those that have over earned the most. These would include many consumer goods and technology companies that benefited the most from the work from home phenomenon.
In contrast, companies that are levered to consumer services look more attractive as demand returns for such experiences. Healthcare is another area where there should be more pent-up demand than average. Consumer staples should also hold up better than average as earnings growth decelerates more for the average company.
Bottom line, we're starting to hear others suggest it's time to rotate back to the cyclicals. We're not so convinced and think it still makes sense to skew towards defensive quality. Meanwhile, with the Fed moving closer to tapering quantitative easing at this week's meeting, we like keeping just a toe in the cyclical waters with financials given their upside to potentially higher interest rates. In short, keep it closer to the vest on risk until the rate of change on earnings growth is near its trough. This will likely coincide with the completion of the mid-cycle transition.
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