Morgan Stanley Says This Is The “Greatest Risk” To The Market Now

Morgan Stanley’s Chief Equity Strategist is bearish on 2020, and the greatest risk he’s identified for the market next year might surprise you. 

News broke this afternoon that President Trump has signed off on the “phase one” trade deal with China, sending stocks surging higher.

But the legal text of the deal is still in limbo, as it has been since October when Trump and Chinese President Xi Jinping said they had agreed to a deal and documentation would be completed within weeks, and there’s no word just yet on if China will confirm the terms or if it will renege on the agreement.

What’s more, while the “phase one” deal is said to include a commitment from China to buy more U.S. agricultural products and a commitment from the U.S. to roll back up to a reported 50% of tariffs on Chinese goods, many of the thorniest issues that sparked the trade war in the first place won’t be resolved in the deal. And beyond that, there’s always the possibility that things could take a step backward from here, which could send us back into a full throttle trade war.

With all the trade uncertainty, many investors would think trade would be the greatest risk to the market next year. Or even the 2020 presidential election. But Morgan Stanley says the greatest risk for the market next year is something else. Namely, frothy growth stocks.

In a note to clients, Morgan Stanley Chief U.S. Equity Strategist Mike Wilson wrote that the firm still favors defensive stocks and more reliable stock picks heading into 2020, and says investors should adopt a choosier bias in the new year.

“We still think the greatest risk in the equity market remains in growth stocks where expectations are too high and priced,” Wilson wrote in the note. “From a sector standpoint, this is consumer discretionary broadly and expensive software and secular growth stocks.”

Instead, Wilson says, “Focus on what you own, not how much.”

Aside from outperformance from a handful of consumer discretionary stocks like Ulta (NASDAQ: ULTA), Wilson says the sector has lagged the broader market this year as communications, energy, and financial stocks have all pushed the major indexes higher.

And while the market’s internal performance may not seem all that important, Wilson says the composition of equity outperformance shows that Wall Street may be starting to turn a bit more cautious in an expensive environment.

Many money managers have been cautioning investors about adding much more to their equity holdings on elevated valuations, but Morgan Stanley said it views the rotation out of growth stock in a more defensive light.

“Since the Fed began cutting, [discretionary and other growth stocks] have underperformed the S&P 500 and appear to be breaking down on a relative basis,” Wilson wrote. “Importantly, these groups underperformed [last] Friday when the market was up and earlier in the week when the market was down.”

“Despite a big rally in stocks, we continue to position our overweights / underweights away from growth and toward the more defensive parts of value (Staples, Utilities and Financials,” he said.

Wilson is one of Wall Streets biggest bears heading into 2020 and sees the S&P 500 ending next year at 3,000, -5% below where the index is at today, and said this fall that he expects “disappointing” earnings per share in the year ahead.

“We’d argue that in 2018, an aggressive Fed quashed one of this decade’s best years of growth, while this year, the Fed elevated asset prices despite broadly slowing growth – something we identified well in 2018 but missed this year,” Wilson wrote in November. 

“However, we expect that by April, the liquidity tailwind will fade and the market will focus more on fundamentals,” he added.