Morgan Stanley Sees 10% Upside in 2015; Downgrades (Healthcare, Tech, Utilities, Ind.), Upgrades (Financials, Energy)
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Morgan Stanley strategists Adam Parker issued his 2015 U.S. Equity Outlook and is bullish for the third straight year. The firm's 12 month forward target for year-end 2015 is 2275, offering about 10% upside to today’s price, based on 7% earnings growth in 2015 and 2016 and modest further multiple expansion to near 17x forward earnings.
Despite the overall bullishness, Parker made a number of changes to his recommended sector allocations:
1) We are downgrading healthcare from overweight to market-weight: "After recommending healthcare for the last four years, we are now reducing our outlook based on more balanced risk-reward. We now hold a 15% position in healthcare, vs the S&P500 benchweight of 14% and our prior bet of 20%. While we still prefer healthcare to consumer staples among the classic defensive sectors, healthcare price-to-forward earnings multiples have now expanded to ten year highs and look more in-line with group multiples from the 1980s and 1990s. Moreover, we are concerned about drug price inflation and its impact on business for the distribution industry, among others, given this is an area we have been overweight for nearly four years. We are reducing our position in (NYSE: CAH) from 4% to 2%, though we retain our 4% position in (NYSE: MCK), viewing its more stable earnings outlook post the Celesio deal as a positive. We are removing our 4% position in (NYSE: BMY), due to strong appreciation, less compelling valuation, and a recent downgrade by analyst David Risinger. We are adding 1% to our position in (NASDAQ: BIIB), now 3%."
2. We are downgrading technology from overweight to market-weight. "In our overall portfolio we have outperformed the S&P500 by roughly 1100 basis points over the past four years, despite a 700 basis points drag from poor stock selection in the technology sector. The culprit has been that it has been extremely difficult to implement a quantamental investment discipline in technology and we have moved outside the discipline to find ideas. Human intervention, at least by us, hasn’t been kind in this sector. For instance, today, there is only one stock in the entire technology sector with an Overweight rating by a Morgan Stanley fundamental analyst that screens in the top quintile of our 3-month alpha model MOST and our 24-month alpha model BEST – (NYSE: HPQ). We already have a 3% position in HPQ and the stock is up roughly 50% over the last 12 months. We are lowering our technology weight from 23% to 19% vs. the sector benchweight of 19.7%. We are removing (NYSE: VMW) (rated Equal-weight) and lowering our weight in (NASDAQ: WDAY) from 3% to 1%. While we like WDAY's long-term growth potential, we are worried about the near-term slowdown, and our analyst is not recommending the stock. We are also trimming 1% from our (NASDAQ: AAPL) position. While we plan on buying several Apple Watches, the stock has nearly doubled over the past three years and our optimizer simulations have consistently."
3) We are downgrading utilities from market-weight to underweight: Honestly, this isn’t a big deal relative to the S&P500 benchweight, as we are lowering our bet from 2% to 1% vs. the benchweight of 3.1%, by removing our longstanding 1% position in (NYSE: DUK). We do think the strong outperformance of utilities could be poised for a break, particularly if bond yields slowly back up, though our confidence in the bond call is equal to or less than our confidence in forecasting short-term price-to-earnings ratios for the S&P500.
4) We are downgrading industrials from market-weight to underweight: We haven’t been recommending industrials for a year, and this is just a 1% reduction (removing Equal-weight rated (NYSE: GE)), lowering our sector weight from 9% to 8% vs. the benchweight of 10.5%.
5) We are upgrading financials from underweight to market-weight: During our mid-year outlook we went underweight financials, believing that a delay in the expectations for Fed action on the front end and lower long-bond yields should be an incremental negative. The sector has modestly outperformed the S&P500 since then (about 1%), despite a less favorable rate environment. Nonetheless, we are constructive on the duration of the cycle and viewed our change in recommendation as more tactical than structural. We continue to prefer retailers to banks based on lower expectations for the holiday season, but have raised our financials weight form 13% to 16% vs. the S&P500 benchweight of 16.3%. We have added (NYSE: AXP) to the portfolio on its recent pullback, as it screens well and is among analyst Betsy Graseck’s top ideas. We also added 1% to our position in (NYSE: JPM) given it screens well in both our 3-and-24-month alpha models
6) We are upgrading energy from market-weight to overweight: This may be a contrarian call, and frankly as little as a week ago we thought it was too early, but we are adding 2% to our energy position, bringing us to 12% vs. the S&P500 benchmark weight of 9%. Our energy upgrade is in part based on a stabilization of Brent crude in 2015. While there's ample precedent for energy stocks to work with negative earnings revisions, particularly with relative valuation support this compelling, we worry our upgrade could be premature if oil falls to cash cost. On the flip side, our confidence in our contrarian overweight in consumer discretionary would further strengthen. While energy earnings revisions will assuredly be the most negative of any sector in the market, this doesn't always mean the sector underperforms. We are adding 2% to (NYSE: SLB), and 1% to ((NYSE: OXY), given they both screen well and are rated Overweight, reducing by 1% our position in (NYSE: APC).
7) Other changes: We are adding a 2% position in (NYSE: SFM), given Vincent Sinisi’s recommendation and quantitative support. This brings up our consumer staples weight to 5% vs. the benchmark of 9.7%, leaving us with a large underweight. We retain our 17% position and large overweight in consumer discretionary (benchweight is 11.8%), by adding 1% to our (NYSE: LVS) position, 1% to (NYSE: HOT) (supportive of the Millennials theme established in our recent five-year consumer outlook note), and removing (NYSE: TRW) (which received a tender offer). We also added 2% to (NYSE: X) and 2% to (NYSE: VZ), as both screen in the top quintile of MOST and BEST and are rated Overweight.
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