Authored by Michael Wilson, chief US equity strategist at Morgan Stanley
Heading into 2020, sentiment was at a high. In fact, based on data we track, investors hadn’t collectively been that bullish since January 2018, right after the biggest tax cut for US corporations and individuals in over 30 years.
In my view, the drivers of bullishness at the end of 2019 were more about fears dissipating and extraordinary liquidity than general excitement about growth acceleration like there was two years ago. Specifically, concerns about an extended trade dispute with China, unresolved Brexit negotiations and slowing global growth all abated. These fears peaked in the summer/fall and by the end of 2019 equity markets were overbought and fearless once more.
While it’s often impossible to identify the catalyst for an overbought market to correct in advance, it’s easy in hindsight. In this case, the coronavirus provided a big enough scare for the markets to experience their largest correction since early October. However, looking at a chart of the S&P 500 or the Nasdaq, one could say, “What correction?” The fact that we only sold off a paltry 3.5% on valid growth concerns suggests that the buy-the-dip mentality and the liquidity-driven bull market are very much in charge. This impressive resilience makes our 1H20 bull case target of 3500 look more likely while 3100 provides support.
Besides liquidity, the other reason why the pullback may have been so shallow is that, under the surface, the correction was much more substantial, with many stocks and assets off more than 10%. Anything sensitive to the global economy, especially China, corrected sharply, while defensively oriented assets and safe havens soared. This makes sense, but we’re coming off several years when cyclicals have already underperformed defensives by a wide margin, so cyclical assets are now discounting a pretty bad outcome. What’s more, with volatility recently touching record lows, this move felt bigger than it was simply because we hadn’t see one in a while. In short, the correction was significant in the hardest-hit assets, leaving sentiment about the growth acceleration quite modest and pushing investors even further into large-cap, high-quality, defensive growth assets like the S&P 500.
At this point, the low growth, low interest rate environment we’ve been in has created tremendous dispersion in the markets between the winners and losers. Three trades in particular have received the most attention:
- large over small,
- defensives over cyclicals, and
- growth over value.
Most investors have figured this out, which is why these trades have worked, but now they’re crowded, and the latest growth scare has taken these trends to new extremes. Is it time to think about the other side of the story?
Our economics team believes that the coronavirus will delay the global recovery but won’t derail it. If that’s right, these unloved parts of the market may finally be ready to outperform in a more sustainable fashion. After the recent correction, such stocks initially traded very strongly, with one of the largest factor reversal days on Wednesday toward cyclical value and small caps, but that quickly faded later in the week. Over the past few years, there have been numerous false starts toward a pro-cyclical, small-cap rotation. Since June 2018, we have fought the urge to trade these short-lived rallies and recommend cyclicals or small-caps, but we have to admit we’re intrigued by this latest correction and the evidence suggesting that the global economy could snap back quickly once the economic headwinds from the coronavirus fade.
Interest rates, commodity prices and USD have been our beacons for cyclicals and small-caps, and each of them still appears unconvinced that growth is going to turn up, at least immediately. While the recovery may not be derailed, the delay is probably enough to keep the three trends in place for now while high-quality indices like the S&P 500 continue to be supported by liquidity and near record-low interest rates along with the view that global growth is good enough to weather this latest threat.
Bottom line, the liquidity-driven bull market is intact but it’s too early to bet big on new trends in cyclical value or small-caps.