Morgan Stanley says stocks are due for a drawdown and there are 3 catalysts that may cause it

Published Mon, Jan 4 202110:08 AM EST

Jesse Pound @/in/jesse-pound @jesserpound

(This story is for CNBC Pro subscribers only). The stock market is set up for a potentially rocky start to 2021 after a strong performance last year, according to a client note from Morgan Stanley. Investors enter the new year with elevated levels of optimism and high valuations on stocks after a 16.3% gain for the S & P 500and a 43.6% gain for the Nasdaq Composite in 2020, and that could make markets susceptible to downside risks, the note from equity strategist Mike Wilson said. "Extreme optimism and/or high valuations are necessary but insufficient conditions for a meaningful equity market correction. Nevertheless, we must acknowledge that the "risk reward" of the US equity market has deteriorated materially and the market is ripe for a drawdown," Morgan Stanley said. The firm identified three potential catalysts for a negative turn in stocks, including Tuesday's Senate runoffs in Georgia. If the Democratic challengers were to win both races, that would give the party control of both houses of Congress as President-elect Joe Biden takes office and raise the changes for a tax hike. Investment firm Oppenheimer said wins for Democrats in both races could spark a 10% contraction for stocks . The second catalyst was possibly soft guidance from companies during the fourth quarter earnings season. Some of the optimism in the equity market can be attributed to confidence in an economic recovery during 2021 and a return to form for companies that were hit hard during the pandemic. However, if major companies signal a later-than-expected recovery or continued uncertainty, it could take a bite out of the market, Morgan Stanley suspects. The third potential catalyst was regulation in the cryptocurrency market, which surged toward the end of 2020 in a way that Morgan Stanley described as "exuberance." Bitcoin has already suffered a major pullback in 2021, as a sell-off on Monday saw the cryptocurrency drop more than 10% in a 24-hour period , according to CoinMetrics. To be sure, the Morgan Stanley strategy team still believes that the U.S. is in a long-term bull market, saying, "bull markets born during a recession typically last for years, not months."

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(This story is for CNBC Pro subscribers only).

The stock market is set up for a potentially rocky start to 2021 after a strong performance last year, according to a client note from Morgan Stanley.

Investors enter the new year with elevated levels of optimism and high valuations on stocks after a 16.3% gain for the S&P 500and a 43.6% gain for the Nasdaq Composite in 2020, and that could make markets susceptible to downside risks, the note from equity strategist Mike Wilson said.