A slump in tech stocks may explain the market rotation – but it’s
the earnings season that investors need to watch, says CIO and
Chief US Equity Strategist Mike Wilson.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan
Stanley’s CIO and Chief US Equity Strategist. Along with my
colleagues bringing you a variety of perspectives, today
I'll be talking about the recent rotation toward more
cyclical parts of the equity market.
It's Monday, Oct 14th at 11:30am in New York.
So let’s get after it.
Last Monday, we upgraded cyclicals relative to defensives after
taking profits in our defensive overweight two weeks
prior. These calls come on the back of September's strong jobs
report and our economists' expectation for the Fed to still cut
interest rates into next year. The resilient labor report
effectively reverses the softness we saw in labor markets over
the summer which had re-introduced hard landing risks into the
markets, driving big outperformance in bonds and defensive
stocks. In short, it was a good time to lock in profits
after an historically good run.
Indeed, cyclical stocks have delivered better performance with
these improved macro data. Importantly, the rates
market is confirming this move. Oftentimes, the rates market
tends to hold onto growth risks longer than the equity
market. Thus, the recent move higher in yields following
resilient data suggests the bond market pricing is shedding some
of its growth concerns, and giving us more confidence in our
cyclicals upgrade.
Furthermore, our cyclical overweights at the sector level in
Industrials, Financials and Energy are all exhibiting a positive
correlation to rates. Conversely, defensives are exhibiting a
negative correlation to yields. In other words, good macro data
is still good for many large cap cyclical stocks, while it's
bad for defensives. Thus, further stabilization in the economic
surprise index should continue to support quality
cyclicals' relative performance even if it comes amid higher
yields.
Meanwhile, positioning in cyclicals remains light amongst
our institutional client base. This is particularly
true for Financials. In our view, this creates opportunity in a
sector that we upgraded to overweight last week. This upgrade was
based on rebounding capital markets activity, a better loan
growth environment in 2025, an acceleration in buybacks post
Basel Endgame re-proposal, and attractive relative valuation.
Finally, we also factored in the notion that several large cap
bank stocks had de-risked in mid-September with lowered guidance
ahead of earnings season. Initial results from earnings season
last week indicate that large cap banks are clearing that lowered
hurdle. On the other side of the coin, positioning in defensives
and quality growth remains extended. This is consistent with our
conversations with clients who generally remain positioned for a
soft macro growth regime.
Given the significant influence of the Magnificent 7 stocks on
the overall direction of the S&P 500, investors remain
focused on how this group of stocks will trade into year-end.
It's notable this cohort has underperformed since the second
quarter earnings season, and relative performance just took
another leg lower. The breadth among this group has
been somewhat narrow with only one of the seven making new highs
since the summer in both absolute and relative terms. In our
view, this may be one of the reasons for the better
performance in other areas of the market and is a potential
driver of further broadening into cyclicals. Of course, if the
market reverts back to these stocks, it’s a risk to
our cyclical upgrade.
Earnings season will be an important factor in terms of these
rotations. The fundamental reason for the underperformance of the
Magnificent 7 could simply be the deceleration in earnings growth
from the very strong pace last year. If this
underperformance continues, it could provide further fuel for the
quality cyclicals to continue to do better as we expect.
Conversely, if earnings revisions show relative strength for the
Mag 7, these stocks will likely outperform once again and market
leadership may narrow—like it did during [the] second quarter and
all of 2023.
Thanks for listening. If you enjoy the podcast, leave us a review
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friend or colleague today.
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