Morgan Stanley says buy these quality growth stocks amid a toppy market

Andrew Wilson, chief executive officer of Electronic Arts Inc. (EA), speaks during the company's EA Play event ahead of the E3 Electronic Entertainment Expo in Los Angeles, California, U.S., on Saturday, June 10, 2017.
Patrick T. Fallon | Bloomberg | Getty Images

Investors should be prepared for some disappointment over the next 12 months as incremental profit margins are reaching unsustainable highs due to supply constraints and the coming increase in corporate taxes, according to Morgan Stanley. Investors should buy quality stocks with growth characteristics to combat this tough market environment, the bank said.

The market has been so-called de-rating lower, meaning valuations are coming down, as stock prices haven't moved following companies' first-quarter earnings results, which came at a peak quarter for monetary and fiscal policy stimulus, Morgan Stanley said in a note to investors Tuesday. The bank expects that process is far from over and the market has yet to see another 15% decline in price-to-earnings ratios, it said. That means share prices are likely to pull back.

While higher earnings over the past year have been "undoubtedly a good thing," they're a "'known known' at this point and no longer a surprise," Morgan Stanley said in the note. "Consensus forecasts are now baking in what appear to be unrealistic margin assumptions."