Morgan Stanley says the market correction won't end until investors cut risk exposure

Published Mon, Feb 1 202110:48 AM EST

The major averages are coming off their worst week since October as a retail trading frenzy spooked investors, and Morgan Stanley believes there's more downside ahead. However, the firm doesn't believe the market is in a full-fledged bubble. "We don't think the correction is over until leverage is reduced further by both institutional and retail investors," Michael Wilson, Morgan Stanley's chief equity strategist, said in a note to clients. "While this correction is likely to get worse and feel bad in the short term, this is not a bubble or like 2000 for many reasons," he said. Wilson has been calling for a correction for several weeks now, but a catalyst to spark the downturn was missing. But no longer. The short squeeze in stocks including GameStop and AMC Entertainment over the last few weeks has forced hedge funds to sell other holdings in order to cover losses from short positions. Morgan Stanley believes investors will continue to de-leverage regardless of whether the targeted short squeezes persist. Even if the coordinated buying, fueled by social media sites including Reddit's WallStreetBets forum, stops, volatility is likely to remain elevated which should lead to further reductions in overall market exposure. But while the firm believes the selling is slated to continue, Wilson noted that "pockets of speculation and exuberance don't make a bubble." While there is some froth, there are several key differences between the current cycle and the dotcom bubble in 2000, he said. For one, the fundamental backdrop this time around looks much better since the market is coming out of a recession. Twenty years ago, stocks were in a late-cycle environment. Wilson is not the only Street strategist to note that the retail trading frenzy provided the spark for a market correction. Tobias Levkovich, Citigroup's chief U.S. equity strategist, said the market's historically high valuation makes it vulnerable to shocks. "We think that the vulnerabilities are there, and while we do not know precisely which catalysts might emerge or their exact timing (including some of the recent retail-oriented pushes against heavily shorted stocks), we suspect that they would derail the current rally and provide entry points that may be 10% lower," he wrote in a note to clients. Morgan Stanley said the recent pullback in some of its favorite trades was warranted after stocks' run from the March low, meaning investors can use recent weakness to add to their portfolios. Specifically, the firm likes cyclicals and defensive names. "Bottom line, use this correction to add to these themes and ideas but be patient until the leverage readings fall further," Wilson said. - CNBC's Michael Bloom contributed reporting.

Traders on the floor of the New York Stock Exchange.

Source: New York Stock Exchange

The major averages are coming off their worst week since October as a retail trading frenzy spooked investors, and Morgan Stanley believes there's more downside ahead.

However, the firm doesn't believe the market is in a full-fledged bubble.

"We don't think the correction is over until leverage is reduced further by both institutional and retail investors," Michael Wilson, Morgan Stanley's chief equity strategist, said in a note to clients.

"While this correction is likely to get worse and feel bad in the short term, this is not a bubble or like 2000 for many reasons," he said.