Morgan Stanley sees growing risk of 20% plunge in S&P 500 as market is transitioning

Morgan Stanley foresees there is a possibility of a plunge of more than 20% in U.S. stocks, causing the S&P 500 to slump nearly 2.8% on Monday.

Although it is a worst-case scenario, the bank said the odds of correction are increasing as the market is transitioning, leading to weaker growth and falling consumer confidence.

In a note on Monday, Morgan Stanley analysts led by Michael Wilson laid out two directions for the near-term risk path for U.S. markets, which they dubbed as “fire and ice” as the market is moving to its next stage mid-cycle transition, which is expected to be “right on schedule,” especially given the fiscal stimulus during the pandemic.

In the “fire” outcome, they expect a more optimistic outlook that would occur if the Federal Reserve begins to remove the stimulus to keep the economy from running too hot.

“The typical ‘fire’ outcome would lead to a modest and healthy 10% correction in the S&P 500,” Wilson wrote.

However, the strategists said that the more bearish “ice” scenario is gaining more traction, which would be “destructive” and would translate to a 20% correction in the S&P 500.

“Will it be Fire or Ice? We don’t know, but the Ice scenario would be worse for markets, and we are leaning in that direction,” the Wilson wrote. “We think the mid-cycle transition will end with the rolling correction finally hitting the S&P 500.”

The analysts pointed to downside risk to earnings revisions, consumer confidence, and Purchasing Managers’ Index, which measures the direction of economic trends in the manufacturing and service sectors.

“These indicators are all highly correlated to S&P price on a rate of change basis, and thus we highlight what downside in these measures could mean for the S&P 500,” strategists wrote.

The bank recommended that investors be more defensive and refer quality companies to protect themselves from the Ice scenario while “keeping a leg in financials” to participate in a Fire outcome.

“Many commentators and clients continue to point to the S&P 500 near all-time highs as a leading indicator and rationale for even higher prices ahead,” the analysts said. “However, in our view, the relative strength of the S&P 500 and Nasdaq 100 is further confirmation that the market understands the mid-cycle transition narrative.”

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