Expect the stock market's winners to keep on winning - until this happens, Morgan Stanley's top strategist says

By Joseph Adinolfi

Michael Wilson says to stay invested in high-quality growth stocks until something changes. He has a few ideas about what such a change might be.

There has been a stark divide in the U.S. stock market recently between winners and losers. Morgan Stanley's top equity strategist, Michael Wilson, expects the winners to keep on winning - and he is recommending that clients keep their portfolios positioned accordingly.

But in addition to maintaining an ample allocation to the high-quality large-cap growth names that have dominated the market in 2024, Wilson also recommends holding on to some defensive names, just in case.

His reasoning revolves around the notion that the U.S. economy is nearing the end of the business cycle, a period typically defined by slowing growth and a winnowing in equity-market leadership. The strong performance seen by a handful of high-quality megacap stocks so far in 2024 suggests that investors are becoming more focused on the state of the economy and less concerned with inflation.

"With macro data broadly coming in softer [year to date], many lower quality and economically sensitive areas of the market have lagged behind, while a narrow list of higher quality mega caps have carried performance," Wilson said in a report shared with MarketWatch over the weekend.

Bears have cited the market's overreliance on a handful of stocks like Nvidia Corp. (NVDA) as a potential vulnerability for large-cap indexes like the S&P 500. But the Morgan Stanley team ran the numbers and found that narrow market breadth isn't a sign of weak returns over the near term.

Instead, the S&P 500 often continues to climb, even when breadth - which Morgan Stanley measured as the percentage of U.S.-traded stocks among the top 500 by market capitalization that are outperforming the cap-weighted index - becomes extremely narrow.

Morgan Stanley's breadth figure was hovering around 20% recently, its weakest level since at least 1965. In the past, when this figure has fallen below 35%, the cap-weighted indexes have still managed to return 4% over the next six months on average, while the average equal-weighted return is 5%.

"Bottom line, narrow breadth can persist but it's not necessarily a headwind to forward returns in and of itself. We believe broadening is likely to be limited to high quality/large cap pockets for now," Wilson said.

So the current crop of stock-market leaders will likely continue to outperform until something changes, Wilson said. As for what that change might be, the strategist has envisioned a few scenarios that could either see the current crop of top-performing stocks fall behind or trigger a broad-based retreat.

Among them would be a reacceleration of economic growth and inflation. In this scenario, market leadership could shift in favor of laggards like small-cap stocks, regional banks, members of the Dow Jones Transportation Average and lower-quality cyclicals, Wilson said.

A sudden spike in the Treasury market term premium could provoke a widespread selloff similar to what investors witnessed last fall, he added. While such a development seems unlikely given the number of options available to sop up liquidity in the bond market, including, most recently, the Federal Reserve's decision to start reducing the amount of bonds permitted to roll off its balance sheet every month, it is still worth keeping in mind.

Finally, the most plausible threat to stocks heading into the summer would be a growth scare that threatens to transform disappointing economic data into bad news for the market. While high-quality large-cap names should continue to do better than the average stock in this scenario, defensive names would likely seize the mantle of market leadership - although in such a scenario, this would likely occur amid a backdrop of falling stocks.

"Until the bond market pushes back via a higher term premium, or growth slows down in a more meaningful way, we expect this narrow market performance to persist," Wilson said.

U.S. stocks were trading mixed on Monday, as many of the megacap stocks that have powered much of the market's advance in 2024 declined, while seemingly the rest of the market rose. As a result, the highflying, technology-heavy Nasdaq Composite COMP was underperforming, down 31 points, or 0.2%, at 17,659, while the S&P 500 SPX rose 19 points, or 0.4%, to 5,483, according to FactSet data.

The Dow Jones Industrial Average DJIA, which is more heavily weighted toward financial stocks and other cyclical sectors, was up nearly 400 points, or 1%, at 39,527, on track to climb for a fifth straight day, Dow Jones Market Data showed.

Until recently, Wilson had been one of the few holdouts on Wall Street with a pessimistic view on stocks. But he finally changed his tune in May, when he released an updated S&P 500 target calling for the index to hit 5,400 by midway through 2025. The S&P 500 has already surpassed that target.

-Joseph Adinolfi

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06-24-24 1230ET

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