The S&P 500 is vulnerable to a correction of up to 15% with tech-stock valuations at dot-com bubble levels, Morgan Stanley says

Trader worried
  • The odds of a 15% stock market correction are rising, according to Morgan Stanley Wealth Management’s Lisa Shalett.
  • The CIO noted that technology stocks that dominate the S&P 500 are at levels not seen since the peak of the dot-com bubble.
  • The tech sector’s profitability and earnings are vulnerable and could pose a risk to the broader market, she said.
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The odds of a stock market correction of up to 15% are rising as lofty technology stock valuations leave the broader market vulnerable, according to Morgan Stanley Wealth Management’s chief investment officer.

In a Monday note, Lisa Shalett highlighted how low rates have helped prop up tech stocks to dot-com era valuations. The price to sales ratio of the technology sector is at a level not seen since the peak of the dot-com bubble in 2000, she said.

In addition, the tech sector now makes up a much larger weight in the S&P 500 than in 2000, and has subsequently driven the price to sales ratio of the benchmark index to a level 50% higher than it has ever been.

“The problem with this setup is that tech sector profitability and earnings are vulnerable,” said Shalett. “While secular growth trends may support resilience against small changes in economic growth, the sector now faces unprecedented headwinds from rising input costs, a weaker US dollar, fiercer competition, higher taxes, stricter regulations and customer backlash.”

If those headwinds come to fruition for the technology sector, the broader market will be at risk.

She noted that markets tend to be strongest when they are broad based and there is a consensus narrative around what could go wrong in terms of economic outcomes, policy, geopolitics, and regulation.

“As we have noted for the past two months, the market continues to grind to all-time highs on narrowing breadth, while the narrative has also grown increasingly muddled. Thus, the risks of a correction are rising,” she said.

The chief investment officer of wealth management told clients to focus on stock-picking using earnings fundamentals. She also said investors could consider adding to financials stocks as a value-oriented hedge to rising rates.

price to sales ratio chart
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Stocks are in a ‘rolling correction’ despite hitting new highs as the market cycle hits its midpoint, Morgan Stanley says

A Wall St sign hangs at the New York Stock Exchange (NYSE) at Wall Street on March 23, 2021 in New York City.
  • Major US stock indexes are in a “rolling correction” amid a “classic” midpoint transition cycle, Morgan Stanley said.
  • During this period of transition, stocks will remain vulnerable.
  • Morgan Stanley analysts say they favor defensive position and GARP – growth at a reasonable price.
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Major US stock indexes are in a “rolling correction” despite notching a series of new highs, as the market cycle transitions to its midpoint, Morgan Stanley analysts said.

As investors rotate away from higher risk names and as market breadth declines, major indexes will remain vulnerable, analysts led by equity strategist Michael Wilson said in the note.

“Under the surface, financial markets have taken on a much more defensive posture,” the note said.

So far, Morgan Stanley has taken a less optimistic view of the markets compared to other banks. The analysts said that they fully expect the transition and subsequent corrections to be complete by the end of this year.

“It’s common for the market to rotate away from early cycle winners toward larger cap, higher quality stocks,” the note said, adding that the rotation away from previous market leaders and small caps are now underway.

This would mean, according to Morgan Stanley, a forward price-to-earnings that is roughly 18x compared to the current 21.3x.

“Push back to that view has been strong but our conviction remains high based on other moves we have observed in the markets,” the note said.

Screen shot of a Morgan Stanley chart on EarlyCycle/SmallCapsLagging.
EarlyCycle/SmallCapsLagging

Most have blamed extreme positioning and short-covering as well as the Federal Reserve’s hawkishness after its June FOMC meeting, the note said, though the analysts believe otherwise.

“We have taken a different view than the consensus citing the potential for a slow down in the second half of the year due to monetary aggregates’ growth decelerating and peak rate of change on economic and earnings revisions.”

Given this, the note said Morgan Stanley will continue to favor quality and defensive positioning and GARP – growth at a reasonable price.

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What is a stock market correction? How to make sense of sudden drops in the market

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Market corrections are normal part of investing.

  • A stock market correction is a brief 10%-20% dip in the value of individual stocks or the overall market from its most recent peak.
  • Market corrections occur on a regular basis and are important for preventing artificially inflated stock prices.
  • They are nothing to worry about in most cases, as long as you’re investing long-term.
  • Visit Insider’s Investing Reference library for more stories.

There’s nothing quite like the rush of watching your investments gain value. The same could be said about the moment of panic when you see them start to take a tumble.

However, it’s common to see plenty of ups and downs in the market. And a dip isn’t always necessarily bad.

Many of these dips are stock market corrections, and understanding what that means can help you better manage your portfolio and protect your wealth.

Here’s what you need to know about stock market corrections and why they matter.

What is a stock market correction?

A stock market correction is a brief dip of 10%-20% in the market or individual stock that occurs to correct artificially inflated stock prices and unsustainable growth. They typically last a few months, although some last only a few days.

To help you understand the difference of a few key ways investors describe the market, here’s a brief rundown:

  • Correction: A temporary decline in the market
  • Crash: An unforeseen and sudden drop in stock prices, often signaling wider economic turmoil
  • Bear market: A widespread and prolonged decline of 20% or more in market prices
  • Bull market: When the market condition is on an upward trend for a sustained period of time

A stock market correction can occur for a number of reasons. Many investors chase market trends, so if people are buying a stock because they believe it will rise in value, others are likely to follow suit. This causes the price of that stock to rise. As this happens, some investors who hold that stock may begin to sell in order to turn a profit while the price is high, as will others, causing the stock price to dip temporarily.

This can happen on a larger scale as confidence in the market waxes and wanes. Good news can artificially inflate stock prices, and sometimes the market reaches a point when demand for stocks goes down, forcing investors who want to sell to lower prices.

What are the effects of a market correction?

In these situations, the market dips to correct itself to avoid a market crash. This typically occurs during an overall period of growth.

Historically speaking, most market corrections have not gone beyond a 20% decline, and they often resulted in a bounce back to normalcy or even a bull market – that is, a period of significant growth.

However, it is possible for a market correction to transform into more dire conditions. If a decline surpasses 20% and lasts for a sustained period of time, it transforms into what’s known as a bear market. These periods of market decline are often accompanied by economic stagnation and increasing rates of unemployment. Sometimes they can lead to a recession.

While this describes the effect on the market as a whole, it’s important to note that not all stocks react to a correction equally. High-growth and more volatile stocks tend to be the most reactive, while non-cyclical stocks, such as defensive stocks will be less impacted.

Why do market corrections matter?

Market corrections can impact the performance of your stocks so it’s always a good idea to know when it’s happening.

In general, market corrections impact most long-term investors minimally, as long as it doesn’t evolve into a recession. A brief dip isn’t troubling as long as your portfolio continues on a general upward trend, so time will likely be on your side.

This is even more true if you’ve diversified your portfolio by holding stocks in a wide range of sectors. This includes non-cyclical stocks, also known as defensive stocks, which tend to perform well even under slowed market conditions.

But for short-term investors such as day traders and others attempting to “time the market,” market corrections can present both significant opportunities and obstacles.

On the one hand, a market correction can be a good time to purchase valuable stocks at discounted prices. On the other hand, this is quite risky, as stocks could continue to dip further. Being forced to sell during a dip can be an expensive mistake.

Some investors will attempt to predict market corrections using market analysis and by comparing market indexes to purchase at a low. But it’s difficult to know for sure when it will happen and what the end result will be. For this reason, it’s generally a better idea to keep your portfolio diversified and rely on long-term growth rather than short-term gains.

As you near retirement age, you can rebalance your portfolio regularly and shift your investments toward more stable assets such as bonds. This will protect your portfolio from losing value at a point when you don’t have enough time left for it to recover.

The financial takeaway

Stock market corrections can be scary, but they’re a natural part of how the market behaves. If there’s one rule to follow in investing, it’s not to make impulsive decisions based when the market declines.

Knowing what a stock market correction is and how it works can help you better understand the nature of your investments so you can manage them more efficiently.

Some may use corrections in an attempt to time the market, but you’re more likely to benefit by simply using this knowledge to remain steadfast when your portfolio takes a hit rather than selling at a loss. When it comes to the stock market, having patience and ensuring you have a diverse portfolio during dips is the best way to go.

8 of the biggest stock market crashes in history – and how they changed our financial livesWhat is a bear market? How to make sense of a prolonged period of decline in the stock market and invest wiselyVolatility measures how dramatically stock prices change, and it can influence when, where, and how you investBusiness cycles chart the ups and downs of an economy, and understanding them can lead to better financial decisions

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