Morgan Stanley downgraded technology stocks to underweight from equal weight on Monday, citing expectations of a more defensive turn in the market.
Cyclical sectors such as technology and consumer discretionary tend to perform better during periods of growth, when investors are more willing to take on risk.
Now Morgan Stanley Chief U.S. Equity Strategist Michael Wilson and his team said it's time for those high-flying sectors to take a backseat to defensive sectors such as utilities, where business is less affected by fluctuations in economic growth.
Tech is the best performer in the S&P 500 so far this year, up more than 12.5 percent.
"We suspect it will not be immune from the changing attitudes toward risk assets we are seeing across markets and think the sector may have benefitted from a false sense of security the past few months," Wilson said in a report. He noted that earnings growth is already priced in, relative valuation is elevated and the industry is sensitive to growing trade tensions since it is one of the most dependent on China by revenues.
Semiconductors, which tend to lead the performance of cyclical sectors, have "meaningfully underperformed" technology in the last few months, Wilson pointed out.
Source: Morgan Stanley Research
Overall, "we think there is a growing probability that the market is now discounting at least 2 of our 3 necessary conditions for sustained defensive leadership — peaking y/y earnings growth and a top in the 10 Year Treasury Yield," the report said. The final condition, which is an inverted yield curve between the 10-year and the 2-year Treasuries, is just 28 basis points from happening, and the gap between the two is narrowing quickly, it added.
"Waiting for an 'engraved invitation' is never a good idea when anticipating leadership changes."
On Monday, Wilson downgraded small-cap stocks to equal weight based on the view the group has run too far ahead of itself. He also upgraded defensive sectors consumer staples and telecom services to equal weight from underweight.
Morgan Stanley upgraded utilities to overweight on June 18. Since then, the sector has gained 6.3 percent as the top performer in the S&P 500. June marked the first month "showing broad and consistent performance from the defensive sectors," the report said. "We think this is likely to continue and could portend a more difficult market environment overall as we enter the seasonally worst time of the year."
Wilson pointed out the S&P 500 typically trades poorly in July and August of midterm election years. "Given the highly uncertain nature of this year's election, we suspect this year could prove to be worse than average," he said.
Source: Morgan Stanley Research. As of July 5, 2018.
Stocks rose Monday morning after Friday's better-than-expected employment report.
Wilson maintained his 12-month S&P 500 target of 2,750, but expects the index could rise to 2,800 to 2,825 in the near term, or up at least 1.5 percent from Friday's close.
"Our suspicion is that this rally may prove to be a bull trap that provides the perfect opportunity to position more defensively. ... We think [the jobs report] will likely encourage the Fed to continue to tighten and may encourage the administration to continue to take a strong stance on trade issues," he said. "After all, economic data like this suggests the trade policies are successful. Neither of these potential actions is good for equity markets in our view."
The U.S. and China each implemented tariffs Friday on $34 billion worth of imports from the other country.