Morgan Stanley's wealth management CIO warns there are 'particularly ominous' signs about the state of the stock market's health — and recommends jumping into these 4 trades during the next major sell-off

  • Morgan Stanley's CIO of Wealth Management Lisa Shalett says there are three "ominous" signs that the stock market is disconnected from reality and will experience a correction.
  • She suggests investors shift to 4 sectors when the correction occurs.
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Since the stock market's rebound from its March low, criticism has been plenty from those who have said the soaring valuations don't accurately reflect the economy, which is still marred by high unemployment and reduced consumer demand.

There are several reasons for what has been the quickest market bounce back in history, including insatiable demand for large-cap tech stocks and anticipation for a COVID-19 vaccine. 

But the Federal Reserve's pledge to support markets for the foreseeable future no matter what has drawn ire from critics, who say the central bank's massive easing efforts disproportionately benefiting the wealthy and well-invested.

"Asset inflation does not solve income disparity. It actually doesn't solve full employment. It doesn't do any of the things we need it to do for it to be a robust economy," billionaire Chamath Palihapitiya said on CNBC in May. "What it does is it allows people who play in the financial markets to make money." 

The time may be coming, however, when this disconnect rears its head in the market. That's according to Morgan Stanley's Chief Investment Officer for Wealth Management Lisa Shalett. 

3 signs the market is disconnected from the economy, and where to invest when a correction comes

Shalett says there are three warning signs that the market is disconnected from reality and will therefore eventually face a correction, defined as a 10% decline from recent highs. The S&P 500 on Thursday fell more than 3.5% during its worst session since March.

The first is that consumer confidence levels are lagging while the market reaches record highs. 

"Historically, year-over-year gains in the S&P 500 and changes in the Conference Board's U.S Consumer Confidence Index match up. In fact, in the past 20 years, the dispersion between the S&P and consumer confidence has never been this wide," Shalett said in an Aug. 31 post. "The just-released headline confidence number fell to a six-year low, worse than the reading in April during the nadir of the economic shutdown. And the S&P reached a new all-time high of 3508 on August 28th."

She also pointed to the fact that the US economy is starting to show signs of a broader recovery, though the market continues to narrow into a handful of tech stocks — just five of them make up more that 20% of the S&P 500 index. 

"Rather than seeing the rising tide lift all boats, correlations between sectors in the S&P 500 index are at an all-time low," Shalett said. "Cyclicals and traditional value sectors are lagging market leadership, which is dominated by a small group of large-cap growth winners, mostly in tech. Financials, which typically perform well during economic rebounds, are languishing."

And third, Shalett said that the underperformance of dividend stocks despite low treasury yields is concerning. 

"When Treasury yields fall, stocks in sectors that tend to be less volatile and offer high dividends usually outperform as investors seek 'bond proxies.' But lately, bond proxies, such as real estate investment trusts, utilities and consumer staples, have been left behind," she said. 

She continued: "Of course, commercial real estate has been hard-hit by the COVID-19 recession, but this dynamic still seems incongruous to me, especially given the outlook for continued low rates and weakness in financial stocks."

The disconnects she pointed out are typically "short-lived," and will lead to a market correction. When that correction occurs, she recommended investors shift into healthcare, financials, materials, and industrials — sectors currently underperforming and which will benefit from a more robust economic rebound, she said.

Investors looking for exposure to these sectors might consider the following exchange-traded funds: the iShares US Healthcare ETF (IYH); the Financial Select Sector SPDR Fund (XLF); the Vanguard Materials Index Fund ETF Shares (VAW); and the Industrial Select Sector SPDR Fund (XLI).

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