MSSB: Equities rally is vulnerable

The following is excerpted from Morgan Stanley Smith Barney’s Global Investment Committee report for February. To read more from the committee, click here.

Global equities have performed strongly during the past several months. From its 2011 low on Oct. 4, the MSCI All Country World Index has gained about 24% in US-dollar terms. Although we did not anticipate this move, the relative performance across regions—with the emerging markets (EM) and the US outperforming Europe and Japan—has been consistent with our tactical positioning within equities.

Can this rally continue? In the next few months, we believe equities are vulnerable to a pullback—if only because the rally has gone such a long way in a relatively short time. In addition, sentiment and volatility measures indicate that complacency is high, and we believe that US economic data are likely to soften as we experience a payback from distortions that have been boosting the data in recent months. One example is distortion from the milder-than- normal winter weather across much of the nation, which has pulled forward some activity that normally would have occurred in the spring.

Recession legacy
The other primary distortion in the equity markets is a legacy of the Great Recession. Analysts at the Economic Cycle Research Institute point out that the plunge in economic activity during the two most severe quarters of the Great Recession—the fourth quarter of 2008 and the first quarter of 2009—were misinterpreted by standard seasonal-adjustment algorithms as signaling, in part, a lasting shift in seasonal patterns. Thus, the seasonal-adjustment factors have been providing a boost to data during the fourth and first quarters and then suppressing the data for the second and third quarters. This partially explains both the recent improvement in a wide range of economic data and the “growth scares” that occurred during the springs of 2010 and 2011, prompting notable equity market pullbacks.

Beyond this potential near-term decline, a key variable for us is whether the US economy will continue to grow at a lackluster pace—which is the consensus view—or slip back into a recession. After all, a downturn in economic activity in the Euro Zone is under way, and, given the substantial trade linkages within the global economy, it is difficult to envision any downturn being confined to one region. Thus, our base-case assumption is that the risk of a US recession remains uncomfortably high. History shows that recessionary environments pose significant challenges to equity markets, at least until investors start to anticipate the end of the downturn.

An earnings upturn?
To be sure, in the absence of a recession, there are reasons to believe that the equity market rally can continue. Valuation is not an impediment, and there are early indications of stabilization in the trend of corporate earnings revisions. A continuation of this development into positive territory would bode well for market performance. However, we caution that earnings expectations, which presumably are synched to consensus expectations about the economic outlook, are vulnerable if growth expectations sour.

All things considered, we are maintaining our modest tactical underweight position in stocks, with a continued preference for emerging markets and the US at the regional level. Although EM valuation has increased with the recent rally, it remains low by historical standards. Moreover, EM central banks generally have shifted their policy focus toward supporting economic growth rather than fighting inflation—a stance that hindered EM equity market performance for the better part of 2011.

Among developed markets, we expect investors to favor the US, at least until there is a sense that Europe and Japan are overcoming structural headwinds that augur extended periods of subpar economic growth or until valuations become more compelling. From a valuation perspective, Europe seems closer to that point than Japan. The Japanese stock market has performed well of late, up 11% in February. However, because of the sharp depreciation of the yen, that gain was only 5% in US dollars. The MSCI Emerging Markets Index increased by about 6% during February.

Large-cap preference
Within US stocks, we continue to favor large caps. We initiated this tactical preference in April 2011 largely based on relative valuation, which had reached extreme readings. Although the valuation advantage is no longer extreme, it remains elevated by historical standards. Since we initiated our preference for large caps, they have outperformed the other two capitalization-size categories.

At the style level, we still have a preference for growth stocks over value stocks—a position we initiated in July 2010. By historical standards, value stocks continue to appear expensive relative to growth stocks, especially in the large-cap sector. During periods of decelerating corporate earnings, growth stocks—companies that have the ability to deliver relatively stable earnings growth regardless of the economic backdrop or those expected to post above-average earnings growth—typically outperform.