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Morgan Stanley sees a potential 10% market correction happening soon -- here's why

Morgan Stanley strategists see a 10% or more market correction in the near future. Yahoo Finance's Brian Sozzi and Julie Hyman break down the details.

Video Transcript

JULIE HYMAN: And as we prepare for the week, and as we sort of set the stage for we're going to see during the month of September, which a lot of folks have said, Brian, is going to be really pivotal month, particularly in terms of the jobs data that we get. But there is sort of this-- I don't know, unease now that increasingly is hanging over the market.

And what's interesting is, it's coming from both the macro end and the micro end. That is, as you pointed out in today's Morning Brief on Yahoo Finance, we're getting a lot of strategists that are cutting their forecasts. Or if not cutting, at least warning that we could see some turbulence. And on the other hand, we're hearing a lot of companies that are cutting their own forecasts, and talking about the threat of higher costs for example, or in some cases, lower demand as a result of the Delta variant.

BRIAN SOZZI: Yeah, and we had another company out this morning, Julie. You have 3M's CFO presenting a Morgan Stanley conference. Now, 3M didn't come out in lower guidance. But they did say that inflation was running a little bit hotter I think than they would have thought, also, ongoing supply chain challenges. And they issued what amounted to a warning. And you're seeing 3M shares under pressure.

But this ultimately fits with some of the things I wrote about in the morning brief newsletter. I encourage everyone to check it out, and click on it, and share it. But you look at JetBlue out there warn last week. You had other major airlines warn. You had Sherwin-Williams come out there warn, PBG warns. So the fundamental backdrop of the market, at least from corporate America is changing for the worse.

I mean, these companies are not telling you the same positive things that drove the market higher pretty much from January to August. And that's why I think you're seeing a lot of really respected people on the street come out here and lower their outlooks for the S&P, and start to warn about corrections. They're not talking about Nouriel Roubini type crash calls that he's been making for the past 11, 12 years that don't even come to fruition.

The S&P 500 is up about 510% since the March lows. We're talking about respected people on Wall Street, like a Mike Wilson, who was on our show last Friday looking for a 10% correction in the market. Here's what he told us.

MIKE WILSON: We're leaning towards that sort of continued slow down being a little bit worse. And the reason why is not because of the virus and Delta, but because we just overshot on the upside so much, right. So the nature of this recovery has been very acute.

One of the reasons we were overly bullish last year is because we said we're going to have a period of over-earning, and operating leverage is going to be surprisingly good. And we got that. In fact, it was even better than we expected. So it would be natural that the mid-cycle transition ends up being worse than normal.

BRIAN SOZZI: And Julie, you peek underneath the hood of the market, obviously, the S&P 500, the Dow, the NASDAQ all get all the focus by investors, as they should. But looking underneath the hood, and I mentioned this in the newsletter, about 90% of Russell 2000 stocks at the small cap index have already fallen into Correction.

Morgan Stanley's own work points out the S&P 500, the average stock is down 10% from its 52 week high. And then Jefferies sent me an email over the weekend noting that cyclical stocks since June 15, the outflows from cyclicals have tallied $15 billion. So the market sentiment is changing. It's just a matter if the S&P 500, and the NASDAQ, and the Dow fall into that technical definition of a correction. Worth noting here, all three major indices are down slightly September to date.

JULIE HYMAN: I'm going to push back against all of this, and play devil's advocate on this, Sozz. And part of it is in what you were just saying. The corrections already happened in a lot of places, right. So you could argue that the sort of negativity that you're expressing has already been priced in.

Maybe it's not priced into the top line S&P 500, but if it's priced into another group energy that has pulled back dramatically since the beginning of the year, and some other sectors in the S&P 500. If it's been priced into the Russell 2000, if it's been priced into some segment of the S&P 500, one could argue that's enough, right. And the other thing that I really want to emphasize here, you know, you're talking about all these companies that are coming out with warnings.

They fall into two categories. The first is the category of travel. The airlines, which have said that they have been hurt by the Delta variant. And that's a fairly limited impact. And as our Adam Shapiro told us last week, many of those warnings were not even as dire as the worst case scenarios.

The other category is, they're cutting because of costs. They're not cutting because of demand. You would be hard pressed to find one of these companies outside of travel, and leisure, and companies that are vulnerable to the Delta variant that is cutting because of demand. It's become increasingly rare.

So what you're seeing is, companies that are saying they're having supply chain problems. They're having higher costs. 3M is another example of that this morning. 3M is not cautious on demand. It's cautious because of costs. And so if we're going to continue to see this strong demand, which many of the CEOs we've been talking to are saying, it's for the foreseeable future, right. The demand is robust. And they don't see it petering out.

And if that's the case, again, it's hard to see that stocks are going to take a tumble just on the cost side of the equation if demand is remaining so robust. Just to take another side of it.

BRIAN SOZZI: Well, I will push back on your push-back, Julie. I think when you saw something like a 3M, there is a component there. In the day, 3M sells tape. I believe they sell pens too. That's stuff that is made for a-- tailor made for the return to offices. That's not necessarily happening at the pace as it was because of the Delta variant.

Secondarily, why the market has completely plunged is, you look at the FANG stocks have essentially held up this market. That bid has remained under these names. But guess what, we're staring down the barrel of a Fed taper. And that will remove one of the biggest sources of this rally since the pandemic lows. That is excess liquidity.

And we have learned time and time again when there is excess liquidity in this market provided by the Fed, those FANG stocks are red hot. That dynamic is going to change in the back half of the year. So the next shoe to drop here could be those FANG stocks.

JULIE HYMAN: It could be. I guess we'll have to wait and see. Maybe.