This bull market is identical to previous bear market ‘retracements,’ says Morgan Stanley

July marked the S&P 500’s fifth consecutive positive month, but Wall Street bears aren’t buying the rally yet.

In a recent research note, Morgan Stanley chief investment analyst Lisa Shalett argued this bull market is a temporary market “retracement” instead of a longer trend.

In contrast to market reversals, a retracement represents a shorter market pivot against a trend, followed by a pivot back to the larger, previous market trend.

“With equities up sharply in the past six weeks, enthusiasm that a new bull market has begun gathering steam,” Shalett stated in a note to clients.

“The rebound over the past nine months looks in line with prior non-recessionary bear market retracements.”

Morgan Stanley believes the rise of the bulls in recent months, driven primarily by “forecasts of a reflationary profit rebound,” may be premature.

“We remain less convinced,” Shalett said.

“In virtually all other non-recessionary drawdowns, not only had the Fed stopped hiking rates by the nine-month mark, but key factors like yield curve inversion and leading economic indicators were not this negative.”

In contrast to the increasingly aggressive market bills, Morgan Stanley sees lagging interest rate moves by the Fed will “be extended.”

What is a policy “lag”?

When the talk turns to the efficacy of policy, economists often bring up the so-called “lag effect.”

In essence, a policy lag is the time it takes for monetary policy to come into full effect. Morgan Stanley believes that although the Fed can adjust rates, it has no control over the lag effect.

Considering the Fed's recent hike cycle was the fastest since the 1970s, that effect could be immense.

Another potential drag of this hiking cycle is the cash cushion individuals and corporate America built up during the pandemic hoarding.

“One of this cycle’s most striking aspects has been the level of money in the system and the extent to which household and corporate balance sheets are less rate sensitive,” Shalett said.

“These factors are consistently fostering extended lags for policy transmission.”

Morgan Stanley is urging investors to slow their roll

“At this time, we anticipate an extended period of volatility,” Shalett stated.

“Investors should take caution and consider portfolio rebalancing and dollar-cost-averaging (i.e., investing similar sums at regular intervals to “average out” purchases of securities at different prices).”

“Also, consider looking for income opportunities in both stocks and bonds,” she added. “Your financial advisor may also be able to help you manage volatility with so-called relative-value and multi-strategy hedge funds.

Last, in an uncertain market environment, “Portfolio diversification across asset classes and regions remains key,” Shalett added.