Morgan Stanley's 3-Alarm Sell Signal

The firm issues a "full house" warning on European equities, fueling big declines in stock markets Wednesday

There have been a number of bearish analyst calls on stocks amid the recent global stock rally, but it took a three-alarm warning from Morgan Stanley (MS) on European equities to catch investors' attention. The note, which was released June 4 but didn't seem to attract the market's attention until June 6, helped spark a big sell-off during the European session and also contributed to big declines on Wall Street, with the Dow Jones industrial average down over 150 points at one point. The Nasdaq and S&P 500 indexes were both off about 1% in afternoon trading.

Indeed, major European indexes, buffeted by interest rate worries after the European Central Bank raised its benchmark interest rate by a quarter point to 4% on June 6, took a big hit. London's FTSE 100 index fell 1.7%, as did the CAC-40 index in Paris. The Dax index in Frankfurt suffered the worst damage on the day, falling 2.4%.

What caused all the fuss? In the note from the firm's chief European equity strategist Teun Draaisma and other Morgan Stanley staff analysts, the company issued a "Full House" sell signal on European equities. "[W]e now have a tactical sell signal as rates are rising and hitting critical levels." The firm pointed to signals from three indicators: A fundamentals indicator, which tripped because of higher bond yields and higher new orders from manufacturers in the U.S, and existing sell signals on its valuation and risk indicators.

"Such a full house sell signal across these three indicators is rare, and has occurred only five times since 1980", the firm said. Equities have always been down in the next six months following such signals, according to Morgan Stanley, on average by 15%, with previous occasions including September, 1987, and April, 2002. "We now have the choice – jump on the strong momentum, or play the odds that our models give us," the firm said in the report. "We prefer to be on the right side of those odds."

Morgan Stanley strategists concurred with some recent thinking on the market: "Yes, we agree that the economy is fine, large caps are cheap and M&A is buoyant." But Morgan Stanley argues that at this stage of bull markets, larger corrections become more frequent, caused by little changes in the macroeconomic environment.

The strategists hedged a bit, noting that cautious investor sentiment can negate a valuation sell signal. "One explanation why our models haven't worked yet in the last few weeks is sentiment: arguably the wall of worry is still being climbed." The firm said its indicators are suggesting an equity market correction, and it is expecting one. "We remain neutral equities, overweight cash, underweight bonds, and continue to have a preference for large caps."

While Morgan Stanley's call on European stocks took a dramatic turn, its view on U.S. equities remains unchanged. In a June 4 note, chief U.S. strategist Henry McVey said there had been no change to the company's U.S. asset allocation. "Despite the additional upside we are forecasting, we do not believe that now is the time to pile into equities." For the U.S., Morgan Stanley continues to have an equal weight rating on stocks, at 65% of its recommended portfolio, while it is overweight cash (10%), and underweight bonds (25%).

Chris Burba, a technical market strategist for Standard & Poor's, says the MS note was a contributing factor to Wall Street's June 6 sell-off. While there may have been some initial confusion as to whether Morgan Stanley was making its call for Europe exclusively or for other markets, Burba notes that "even if it's just for Europe it's still worrisome for U.S. investors." Burba points to other factors weighing on U.S. stocks, including a recent uptick in interest rates and worries about Federal Reserve rate hikes later this year. (S&P, like, is a unit of The McGraw-Hill Cos. [MHP].

European media were a bit late to the party, but they jumped in head first Wednesday as the "Full House" note circulated more widely. "Morgan Stanley has advised clients to slash exposure to the stock market after its three key warning indicators began flashing a 'Full House' sell signal for the first time since the dotcom bust" wrote London's Daily Telegraph on June 6.

A Morgan Stanley spokesman confirmed to BusinessWeek that the sell signal was targeted at European equities. Some of the confusion in other markets may have resulted from early media reports about the release of the note, which "blew things out of proportion," said the Europe-based spokesman, who declined to be identified because of firm policy.

With global equity investors nervous after recent big gains – and more worried about rising inflation and interest rates – a big bearish call from anywhere can spark a rush to the exits.

Before it's here, it's on the Bloomberg Terminal.