S&P 500 may jump 10% in 2021, but action may be in small cap stocks; Morgan Stanley shares top picks

After witnessing a turbulent 2020, analysts have now begun crunching numbers trying to ascertain what road will Wall Street take in the coming year. Morgan Stanley’s Chief Investment Officer and Chief US Equity Strategist Mike Wilson says that he remains a steadfast bull as he looks ahead for the next 12 months. “New bull markets that coincide with a new economic cycle last for years, not months. In other words, this bull has a long way to run,” Mike Wilson said in his weekly podcast. He added that the real action for investors is likely to take place in smaller cap stocks.

Coming out of recession

For the S&P 500, Morgan Stanley predicts a 10% upside over the next 12-month period. This view is aided by earnings that continue to beat estimates due to better topline growth next year, which is expected to lead to extraordinary operating leverage. “This is a typical feature of the first year coming out of a recession. However, we see some constraints on valuations as long-term interest rates are likely to rise more than markets expect over the next several quarters,” Mike Wison said.

Sensitivity to economic recovery

Although he does see a strong upside in large cap stocks, it is the small cap space where he believes the bulls will find some room to run. “The real action for investors is likely to take place below the surface in smaller cap stocks that have greater sensitivity to what is likely to be a very strong economic recovery. We also continue to recommend investors overweight financials, consumer cyclicals and services, materials and industrial stocks,” he said.

Valuation headwinds

Morgan Stanley forecasts a 7.5% nominal GDP growth for the US economy. Here, they say, a 1% 10-year Treasury bond may be extremely mispriced. “This has implications for equity valuations, especially the longest duration ones like the Nasdaq. Conversely, shorter duration cyclical stocks should get a boost from better growth and higher interest rates,” Mike Wilson added. His near-term views, however, do come with certain riders. Mike Wilson believes that valuations of stocks are likely to face headwinds in the near-term owing to higher interest rates and the remaining concerns around the second wave prior to the distribution of the vaccines.