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3 Reasons the Equity Rout May Continue

Over the course of the past week, there has been a marked sell-off in equity markets, leading many commentators to observe that this may be a good opportunity to buy the dip in stocks. While market routs are good times to deploy capital, it is equally important not to jump the gun. This research note from Morgan Stanley (NYSE:MS) outlines three reasons stocks could continue to fall.

Labor conditions tighten in small caps

As we have noted previously, the Morgan Stanley's equity analysts have long been banging the drum for the idea that the U.S. is in a corporate earnings recession. One of their main arguments has been the significant reduction in operating expenses and capital spending, which has now been joined by labor reductions:

"We're also starting to see labour cutbacks by smaller companies, and believe there's now elevated risk that large cap companies may follow too, should earnings and confidence not improve. On that score, the large-cap S&P 500 has EPS growth that's just barely negative on a year-over-year basis. However, the small-cap S&P 600, and the mid-cap S&P 400 EPS growth is down 8% year-over-year, putting these smaller companies in a full-blown earnings recession already."

Shift in market sentiment

Another factor contributing to the fall in equities has been the shift in investor sentiment that has taken place over the last month:

"We argued [the US equity market] would fail one more time as buyers exhausted and sellers reappeared. Momentum would likely do the rest as many analysts and investors have been ignoring the fundamentals simply because the technical picture was strong. With last week's break in trend, that's no longer the case."

We know that many market participants are not motivated by fundamentals. While value investors should not buy into speculative rallies, it is important to understand why others do, and what that might mean for stock prices in the future. So long as momentum and growth traders remain skittish, we are likely to see further declines in prices.

Worsening trade war

"Of course, last week was not just about the Fed, but also included a threat that the US would levy 10% tariffs on the remaining $300 billion of Chinese imports, starting on September 1st. This understandably had a negative impact on margins, but to blame the exhaustion on this event alone would be mistaken in our view, because this risk was always present, particularly given the lack of any progress at the numerous meetings between US and Chinese negotiators over the past few months."

Investors may have been counting on the Federal Reserve's rate cut to make up for the trade war uncertainty. Now that they have seen that the "insurance cut" has failed to juice markets, the full effect of the trade tensions may start to be realized. Supply chains will only get hit harder as the pressure in the U.S.-China conflict is ratcheted up, and it is my suspicion that the full impact of these events is yet to be fully priced in.

Disclosure: The author owns no stocks mentioned.

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