- Morgan Stanley’s Mike Wilson says areas of the stock market are starting to show weakness.
- This is because of supply shortages associated with the economic reopening.
- He shared four trades to mitigate downside risks.
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The consensus trade on Wall Street in recent months has been to pile into cyclical stocks in anticipation of the economic recovery that awaits as vaccinations increase.
But Mike Wilson, Morgan Stanley’s chief US equity strategist, has been saying over the past few weeks that the recovery is now priced in, and that investors should start looking further ahead. He reiterated that call again on Monday.
In a note to clients, Wilson said that sectors such as small caps, low-quality stocks, and others that rise when the economy improves have seen their early-cycle run-ups quicker than expected. And now, the market is transitioning to its mid-cycle phase. This is shown in the chart below.
Wilson also said that despite presumed reopening tailwinds, the above sectors face risks associated with the reopening because of supply shortages, which are expected to lead to price increases and a temporary surge in inflation. Industries from semiconductors to autos and consumer electronics are struggling to keep up with a post-lockdown surge in demand.
“In our view, the breakdown of small caps and cyclicals are potential early warning signs that the actual reopening of the economy will be more difficult than many believe,” Wilson wrote in the note.
“While policy makers have provided tremendous support for the economy with both monetary accommodation and fiscal stimulus, the lockdown has reduced supply, destroying it in some cases,” he continued. “As a result, we are now seeing evidence of supply shortages in everything from materials and logistical support to labor.”
Wilson, who has had an impressive track record over the past year of calling sell-offs and picking sectors, also mentioned the lackluster performances of SPACs and IPOs as signs that stocks may be in for a rough period.
“My experience is that when new issues underperform this much, it’s generally a leading indicator equity markets will struggle more broadly,” he wrote. “When combined with the fact that leverage in the system is very high, it could spell more trouble for riskier, more speculative investments.”
4 trades to mitigate risk
To avoid this weakness in the market, Wilson recommended four trades.
The first was to lessen exposure to small-cap stocks — which have been beaten by the S&P 500 over the past month to the tune of 8% — as they face supply-related risks and could be hurt by rising interest rates.
He also liked lessened exposure to the consumer discretionary sector, with its recovery already priced.
Instead, he preferred higher-quality stocks that tend to be less volatile. Last week Wilson and his team released a list of 25 high-quality stocks they liked that should perform well in any market environment.
One sector he liked for its exposure to quality stocks was consumer staples. Investors seeking exposure to this sector might consider a product such as the Invesco S&P 500 Equal Weight Consumer Staples ETF (RHS).
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