The U.S. stock market has rebounded smartly from its Dec. 2018 low and the bulls anticipate continued gains, but Morgan Stanley is skeptical. "We have been vocal around the idea that we are in a bear market, an environment where defensives typically outperform," as their U.S. Equity Strategy team led by Michael Wilson writes in their most recent Weekly Warm Up report.

"With the US equity market so overbought, fully valued and the beta trade somewhat overplayed at this point, we think it makes sense to keep our overweights on Utilities and [Consumer] Staples," the report adds. In fact, these two sectors are among those that have beaten their expected returns by the widest margins since Sept. 20, 2018, the date of the all-time record high close for the S&P 500.

Morgan Stanley on the Defensive: Favorite Sectors

(Outperformance vs. Expected Returns, 9/20/18 to 2/15/19)

  • Consumer Staples: +2.46%
  • Utilities: +6.48%

Source: Morgan Stanley

Significance for Investors

Morgan Stanley computed expected returns, or projected performance, for all 11 sectors in the S&P 500, plus several industry groups within those sectors, based on their betas, or long-term correlations with the entire S&P 500. From the close on Sept. 20, 2018 to the close on Feb. 15, 2019, the S&P 500 fell by 5.29%.

Utilities should have dropped by 1.44% (implied beta of 0.27), but they rose by 5.04%, representing outperformance of 6.48%. For consumer staples, the expected return was a decline of 3.71% (implied beta of 0.70), but they fell by only 1.25%, for outperformance of 2.46%. Within consumer staples, household and personal products were the standout, with 12.18% outperformance.

"Looking at industry group price reactions vs EPS revisions, we find that several defensively oriented groups (Household and Personal Products, Real Estate and Utilities) appear to be positive outliers on price vs revisions while negative price moves in Retailing and Tech Hardware appear to be overstating the severity of the downward revisions," Morgan Stanley says. These relatively subdued reactions of investors to recent earnings disappointments are part of the report's case for defensives going forward.

"We think idiosyncratic factors and a generally defensive tilt to the market help explain these relationships," the report adds. Real estate beat expected returns by 8.19% in the period from Sept. 20 to Feb. 15.

Among the leading Wall Street firms, for several months Morgan Stanley been the most bearish regarding S&P 500 earnings, and their latest base case forecast calls for profit growth at a mere 1% in 2019. *Our call for a Rolling Bottom is playing out. From the lows in December, the market has rewarded beta almost indiscriminately--the greater the beta, the greater the performance," they say. They project that the global economy will hit its own bottom in the first half of 2019.

Looking Ahead

Morgan Stanley has been leading the Wall Street pack in revising earnings estimates downward in recent months. If their bearish outlook is correct, a tilt towards defensives is a logical response. On the other hand, if the more optimistic forecasts of their rivals pan out, investors may miss significant upside. Further complicating the picture, research by JPMorgan finds recent historical precedents for stock market rallies in the face of plummeting earnings forecasts.

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