For years, one of the primary factors lifting the U.S. stock market has been the fact that some of the economyâs biggest, fastest-growing names just kept rising.
The strength of growth stocks, in particular some large technology and internet plays, has been a boon for momentum investors, who bet that recent outperformers will continue to do better than the overall market over the medium term. This trade has been one of the easiest ways for investors to make money, but analysts are increasingly concerned that its era may be drawing to a close.
Morgan Stanley called for âa breakdown in both legs of momentum,â which it warned âcould be a trigger for a significant market correction.â
Itâs âhard to walk with two broken legs,â it noted in a note to clients published earlier this week.
Major indexes have been trending higher of late; the Dow Jones Industrial Average
recently closed at its highest level since February while the S&P 500
Â has risen for four straight sessions and is now near record levels. The Nasdaq Composite Index
Â is within 1% of record levels.
While recent price action has been positive, however, Morgan Stanley is concerned about how breadth â the number of stocks rising compared with the number falling â was diverging from price.
See also: Why investors shouldnât sweat the stock marketâs reliance on FAANG shares
âFewer stocks are carrying the load of the market, a sign of exhaustion and, in our view, a bad signal for further price gains,â the investment bankâs team of analysts wrote. It added that a recent example of a major stock hitting a notable milestone for strength â Apple Inc.âs
market capitalization cresting $1 trillion â âsure sounds like a âringing of the bellâ to us.â Rather than the $1 trillion valuation being a sign âthat all is right with tech,â Morgan Stanley wrote, it âcould be a meaningful historical market for a tradable top.â
This chart compares the number of Nasdaq stocks hitting 52-week highs with the indexâs price. While the price has been trending higher, breadth has generally been weakening.
Morgan Stanley has turned decidedly pessimistic about the U.S. stock market of late, anticipating a ârolling bear marketâ that hits different parts of the market at different times. Last week, it said the bull market could be in its âlast inningsâ if bears went on to target areas of the market like small-capitalization stocks and the technology sector, both of which Morgan Stanley downgraded in early July. Recent signs of weakness in the market, it wrote, could result in the biggest market selloff in months.
While tech and internet stocks are the most visible âmo-moâ plays, Morgan Stanley said this trend was showing signs of deteriorating regardless of market sector.
âSector-neutral momentum has been breaking down due to the outperformance of defensives and weakness in growth,â it wrote (emphasis in original). âGiven the exposure of both discretionary and quant investors to the momentum factor, lingering weakness here can feed on itself and invite further rotations, which will not be good for price momentum leaders â i.e. Tech and other leading growth stocks â or the market.â
Read: After a decade of wins, the end may be near for one of Wall Streetâs best stock trades
Morgan Stanley is not the only firm sounding caution about momentum trends. According to July data from S&P Dow Jones Indices, the S&P 500 momentum index had outperformed the unadjusted S&P 500 by 15% on a total-return basis since the start of 2017. The firm wrote that this degree of outperformance âhas rarely been exceeded historically and, when it has been exceeded, has tended to predict a subsequent period of weakness for the strategy.â
The last time the momentum factor saw such excess returns on an 18-month basis was in early 2008, as the financial crisis began to pick up steam. After peaking, momentumâs performance relative to the S&P 500 turned sharply lower, and didnât bottom until mid-2010.
But other analysts see Wall Street as primed for a breakout.
In late May, the Wells Fargo Investment Institute also used the image of a broken limb to describe the stock market. However, it suggested that the correction major indexes underwent in early 2018 represented the breaking of the âbone,â and that the lengthy rangebound trading since then â the S&P only recently exited correction territory, while the Dow hasnât yet risen 10% from its correction low, making for its longest stint in correction territory since 1973 â represented a healing of the injury.
At the time, the Wells Fargo Investment Institute wrote that the leg appeared to be nearly healed, citing positive technical trends, like the S&P 500 holding above its 200-day moving average, which it has continued to do as it trends higher.