Morgan Stanley
  • Wealth Management
  • May 26, 2020

Looking for Upside Surprises and Positive Rates of Change

Even when economic or earnings results seem bad, stocks can still rise if the news is better than expected. See some areas where results could surprise.

Lisa Shalett Chief Investment Officer, Wealth Management

Lately, it may feel like the U.S. stock market is moving to the beat of a different drummer. For weeks, the economic headlines were distressingly bad, but the S&P 500 went up anyway. Stocks may seem disconnected from reality, but this is the way the market typically reacts when the economy is transitioning to a new business cycle. The market is essentially discounting the current news and sees better days ahead.

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Stocks aren’t reacting to news based on whether it is objectively good or bad, but whether it is better or worse than current expectations. An economic report can be very poor, but still be deemed positive if it is better than expected. In a similar vein, if first-time jobless claims are high, but rising at a slower pace than the prior week, that’s a sequential improvement—a bad level but a positive rate of change.

As the worst economic news lands and a new business cycle starts, investors should expect that the sectors that performed best in prior years may lag. Our job is to identify areas that we believe will outperform expectations and prepare for the coming shift in sector leadership. Here are some of our early observations:

  • A rebound in residential real estate could fuel consumer spending. Housing is likely to benefit from low interest rates as well as a potential shift away from urbanization and toward working from home in sectors that can accommodate it. Home-buying also is typically a catalyst for spending on furniture and household goods. 
  • Tech giants may be vulnerable. Giant consumer facing online businesses led the previous business cycle and may be challenged to do better in the future than they are now. There simply isn’t much room for them to surprise to the upside as more regions open and people are no longer confined to their homes with digital channels as their main source of recreation and connection.
  • Sectors reliant on capital spending may disappoint. I expect business spending to be slower to recover from recession than consumer spending. While consumers may experience pent-up demand, public companies are likely to be focused on restoring profit margins. Manufacturing has surprised to the upside lately, but increasing trade tensions with China could impede further improvement.

Of course, there are additional sectors that are expected to do poorly and likely will—such as live entertainment, restaurants, commercial real estate and energy infrastructure, to name a few.

Positive economic surprises should quickly lead to improved earnings estimates for companies poised to benefit from increased consumer spending. Keep an eye on sector and company-level earnings revisions. Remember, for markets right now, it is the direction and rate of change that tends to matter, not the actual level of results.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 26, 2020, “Surprises and Rates of Change.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report. 

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. 

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

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