Morgan Stanley issued the following announcement on July 13.

Last week, summer moved into full swing in the United States with one of the steamiest 4th of Julys I can remember. Popup thunderstorms have been epic lately, dropping as much as five inches of rain in just ten minutes near my house. The storms have a parallel with how markets have traded so far this year: unannounced squalls that inflict a lot of localized damage over a very short span but end almost as quickly as they arrive.

In our experience, rolling bear markets aren’t over until they touch every last corner, with the highest-quality areas eventually taken out to the woodshed.

early February and the sharp sell-off in Italian bonds in May stand out as perhaps the best examples of what investors have had to deal with this year. Amazingly, neither of these events led to a broader, more systemic de-risking of portfolios. Instead, prices reset quickly in the affected assets and investors simply moved to higher ground.

This kind of price action is very much in line with our outlook for 2018, a year in which tighter financial conditions have drained liquidity, leading to the weakest links getting hit first and hardest. My colleagues and I who cover U.S. equities have described this environment as a rolling bear market which feels awful at times in specific places, but not everywhere at once. Perhaps it’s easiest to see when comparing regions, sectors or specific stocks.

In other words, the damage below the surface is much worse than if you simply look at the broad indices. However, the higher ground is getting scarcer, with few completely dry areas.

In our experience, rolling bear markets aren’t over until they touch every last corner, with the highest-quality areas eventually taken out to the woodshed. Recall the 2014-16 rolling bear market, during which emerging markets, high yield, and commodities bore the brunt of the pain. It wasn’t until a U.S. recession was priced in during early 2016—hitting both the S&P 500 and the vaunted tech stocks—that the bear market ended. We believe the current environment is very similar. We have been vocal this year, suggesting that a bear market began in December with a peak in valuations, followed by a peak in sentiment and positioning in January. We also said that it would be a very unsatisfying bear market—for the bears.

The bastions of safety in 2018 are the same old stalwarts of the post financial crisis bull market: the S&P 500 at the regional level and growth stocks at the sector and stock level, most notably, U.S. tech stocks. More recently, U.S. small caps have been the safe haven of choice over the S&P 500 as investors view them as less vulnerable to rising trade tensions.

While this makes sense intuitively, we are skeptical that U.S.-centric small cap companies would be immune to a major escalation in trade tensions, which would ultimately be a significant drag on the U.S. economy, too. With the dramatic 800bp of outperformance in U.S. small caps versus large caps over the past three months, we are downgrading our view on U.S. small caps today from overweight to equal-weight.

A More Defensive Sector Tilt

Similarly, we think the risk is rising that U.S. tech and growth stocks will get rained on. While we are not worried about an economic recession as the catalyst for underperformance in these market leaders like it was back in early 2016, we do think that the 2Q earnings season will bring an inevitable acknowledgement from companies that trade tensions increase the risk to forward earnings estimates, even if managements don’t formally lower the bar.

S&P 500 Sector Performance Shows Defensives Beating Cyclicals

(Total Return: June 18, 2018-July 5, 2018)

Source: Bloomberg, Morgan Stanley Research. As of July 5, 2018.

Throw in the fact that these stocks have rarely, if ever, been so over-loved and over-owned, and the risk of a proper rain storm in this zip code increases significantly. We are downgrading our view on the U.S. technology sector to underweight from equal-weight. Conversely, we are upgrading telecom services and consumer staples to equal-weight from underweight today as part of our call to get more defensive this summer as growth peaks, rates top, and the curve flattens.

Finally, while we have been out of consensus with our outlook, we are cognizant that global risk markets have absorbed a lot of bad news this year, not to mention meaningfully tighter financial conditions. We think that our rolling bear market narrative has captured this unusual dynamic quite well. If we are right about growth stocks finally getting wet, it may finally lead to more stable weather in the fall. But let’s not get ahead of ourselves. In the meantime, enjoy what I hope is a dry, pleasant July wherever you are.

Adapted from a recent edition of Morgan Stanley Research’s “Sunday Start” (July 8, 2018) series. Ask your Morgan Stanley representative or Financial Advisor for the latest market strategy coverage and reports. Plus, more Ideas.

Original source: http://www.morganstanley.com/ideas/us-equities-rolling-bear