The Market Could Fall Some More. These Stocks Are Most Vulnerable.

Banks are among the vulnerable stocks if economic demand drops.


Dreamstime

The stock market could be headed for another drop. “Cyclical” stocks are some of the most vulnerable ones. 

The S&P 500 has gained about 9% from its intraday low of the year, hit in mid June—and that could set it up to fall hard. 

The reason starts with the Federal Reserve. The Fed has been raising interest rates this year to bring high inflation—and economic demand—down. The inflation has already prompted companies to reduce earnings estimates as consumer demand wanes. Companies have said price increases have caused consumers to spend less in certain product categories, but that doesn’t necessarily mean that higher interest rates have had their full impact on spending yet. Higher rates usually take a few weeks or a few months to actually reduce spending. 

“There’s more downside pressure coming on growth and the economy over the next several months,” said Jim Paulsen, chief investment strategist at the Leuthold Group. “There’s more to come from the lagged impact of [monetary policy] tightening.” 

If that forces the stock market lower again, select stocks stand to lose a lot. To be sure, a lot of the economic and earnings uncertainty already has been reflected in the stock market with the S&P 500 still down about 17% from its all-time high hit in early January.



Alphabet

(GOOGL), for example, saw its stock pop Wednesday after it missed earnings estimates Tuesday evening because the stock had already priced in a hit to earnings. But for the broader market, one more potential wave of earnings estimate reductions could cause the market to take another dip. 

Cyclical stocks, or those whose sales and profits see a hit when economic demand drops, are vulnerable. They’ve been top performers in the market rally of the past month-and-half, which means any market drop from here would do serious damage to them. 

Consumer services stocks, specifically, could be in trouble. These include restaurant chains and hotel operators, which see lower sales when consumers have less money to spend. Given their historical correlation to the Services Purchasing Managers Index, a measure of economic activity, these stocks suggest the



PMI

should be at a reading of 56, according to



Morgan Stanley
.

Any reading above 50 represents growth in activity, but a recent Services PMI was 47 this month, representing contraction in activity. 

The capital goods industry is also vulnerable. These include manufacturers of large equipment, so their sales are lower when there are fewer building and construction projects. Their recently strong performance implies a manufacturing PMI of 56, but recent readings have been in the low 50s. 

Banks are vulnerable, too. They do less lending when economic demand is weaker and they reserve more cash when consumer and business credit is on shaky footing. Bank stocks’ recent performance suggests a manufacturing PMI of 57. 

“All of these groups listed have further price downside ahead based on this historical regression analysis,” wrote Morgan Stanley’s chief U.S. equity strategist Mike Wilson. 

A lot of this will depend on whether the Fed is willing to dent the economy even more. 

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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