Stocks rose sharply last week, with the S&P 500 index climbing 6.2%, its strongest gain since November 2020. The ascent came even as the Federal Reserve on Tuesday raised interest rates.
But Morgan Stanley strategists, led by Michael Wilson, don’t expect it to last. The economic recovery looks long in the tooth, they wrote in a commentary. “The data analysis suggest we are even later in the expansion than we thought a few months ago.”
Danger on the Yield Curve
One ominous sign: The Treasury yield curve for two-year and 10-year notes is close to inverting, the strategists said. Inversion occurs when short-term rates are higher than long-term rates, which is the opposite from normal. The two-year Treasury recently yielded 2.03%, and the 10-year yielded 2.24%. Morgan Stanley expects a full inversion next quarter.
“While this doesn't guarantee a recession, the signal on growth is clearly negative,” the strategists said.
They’re also concerned about valuations. “The equity risk premium looks far too low to us given the persistent volatility in financial markets, one of the more unstable geopolitical environments we've ever witnessed and rising risk for growth, especially earnings.”
The equity risk premium is the extra return that investors get from putting their money into stocks rather than a low-risk asset, like a Treasury bond.
'A Vicious Bear Market Rally'
So what to make of last week’s stock rally? It was “one of the sharpest on record,” Morgan Stanley strategists said. “While it could go a bit higher, led by the Nasdaq and small-caps, we remain convicted it's still a bear market.” They expect the market’s next down leg to finish by mid-to-late April.
Last week’s enthusiasm may already have worn off a bit, with the S&P 500 little changed in recent trading.
“Bottom line, last week was nothing more than a vicious bear market rally, in our view, and while it may not be completely finished, it is a rally to sell,” the strategists said.
To be sure, experts say you shouldn’t dump a stock when you believe in the long-term strength of a business. And Morgan Stanley doesn’t recommend completely abandoning stocks.
“We would use this strength to position more defensively,” the analysts said. “We upgrade utilities to overweight.” And the firm added utility CenterPoint Energy (CNP) to its Fresh Money Buy List.
