A Late-Cycle Market Doesn't Mean Sell Now: Morgan Stanley

(Bloomberg) -- As the developed world approaches the final stages of an upturn in the economy and financial markets, investors for now should remain invested in equities and avoid the temptation to sell during pullbacks, according to Morgan Stanley.

"Without a doubt, most major asset classes look rich versus history," Morgan Stanley strategists including Serena Tang and Andrew Sheets, wrote in a 40-page plus report on "how the bull market will end." However, "equities can still get richer into end-of-cycle," they concluded.

Current indicators used by the New York-based bank’s cross-asset strategy team are showing strong macro-economic data, favoring a tilt to stocks, with low allocation to high-yield credit. That’s in keeping with credit being one of the first movers down when the cycle ends, according to the analysis. It’s a chance to enjoy the last hurrah for the second-longest bull market in U.S. history, with "elevated" risks for a shift to a downturn next year.

“Sentiment is positive, but not at fever pitch yet,” Tang and Sheets wrote in the report this month. "Leverage build-up and sentiment are beginning to show signs of end-of-cycle excesses, but policy tightening is not yet extreme enough to become a catalyst. For 2018, timing will be key."

A Late-Cycle Market Doesn't Mean Sell Now: Morgan Stanley

Staying the course for equities after the value of the S&P 500 Index tripled to $23 trillion from the start of the bull run in 2009 is a stance that’s coming under increasing scrutiny. An unprecedented number of investors in a recent survey of global money managers said stocks are overvalued, a sign of “irrational exuberance,” according to strategists at Bank of America Merrill Lynch.

Three things typically derail economies and markets at the end of cycles, Morgan Stanley said: excessive policy tightening from central banks, an extreme build-up of debt, and exuberant sentiment. None of these is in place yet, they said.

A Late-Cycle Market Doesn't Mean Sell Now: Morgan Stanley

Morgan Stanley’s list for what to watch that may herald a turn in the cycle included:

  • Peaks in the currencies of emerging markets and commodity producers against the U.S. dollar. That tends to happen 7-10 months prior to tops in the S&P 500
  • Credit spreads typically bottom out about four months before the top for U.S. stocks
  • Deterioration in economic data including manufacturing surveys, durable goods orders and average weekly hours worked can foreshadow peaks in equity markets by 4-6 months

One way to benefit from further gains in stocks during the end of a cycle is to buy call options on the S&P 500 and hedge the possibility that the cycle turns down sooner than expected by owning put spreads on high-yield credit.

Here’s how Morgan Stanley’s team suggests adjusting portfolio allocation during the four stages of each cycle. It suggests keeping some powder dry in cash as prudent at present. The caveat is that the jump from the current expansion phase to the downturn could be fast.

A Late-Cycle Market Doesn't Mean Sell Now: Morgan Stanley

Futures on the S&P 500 Index slid 0.3 percent as of 9:53 a.m. in Hong Kong on Wednesday.

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