Why Stock Investors Shouldn't Sell Now

Investors should remain invested in equities and not get scared into selling by pullbacks in the market, according to strategists at Morgan Stanley 

(MSMSMorgan Stanley48.63+1.10%), as quoted by Bloomberg. In a detailed report of more than 40 pages, Morgan Stanley acknowledges that "most major asset classes look rich versus history," but they add that "equities can still get richer into end-of-cycle," per Bloomberg.

Three factors typically send economies into recession and stock markets tumbling, Morgan Stanley says: excessive tightening of credit by central banks, large increases in debt, and extreme optimism among investors that former Federal Reserve Chairman Alan Greenspan once dubbed "irrational exuberance." Morgan Stanley does not see any of these three factors in place right now, Bloomberg says.

How Long Can the Bulls Run?

Joseph Zidle of Bernstein Portfolio Advisors LLC, recently among the most bullish strategists, now expects excessive tightening by the Fed to be an inevitable recessionary trigger, though he adds that the bull market may have many more months left to run. Meanwhile, another prominent strategist, Jonathan Golub of Credit Suisse Group (CS

Strategists at Charles Schwab Corp. (SCHWSCHWCharles Schwab Corp44.73+0.43%) remain bullish on equities, for a variety of reasons. Among these: December historically sees gains, including the so-called Santa Claus rally; all major world economies continue to grow; corporate profits are still rising; and the markets are habitually shrugging off political risks. (For more, see also: Charles Schwab Upbeat as Impact Conference Kicks Off.)

Investors should be on the lookout for three leading indicators of a downturn in the economy and in equities, Morgan Stanley says. First, when the currencies of emerging market countries and key commodities peak in value versus the U.S. dollar, the S&P 500 tends to reach its own peak about seven to 10 months later. Second, credit spreads, or the difference in yield on U.S. Treasury debt and lower-quality bonds with similar maturities issued by corporate borrowers, tend to bottom out about four months before the U.S. stock market peaks. Third, declining measures of economic activity, such as manufacturing surveys, orders for durable goods, and average weekly hours worked, tend to precede an equity market peak by four to six months.

Actions to Take Now

Morgan Stanley suggests keeping some cash at the ready as a prudent measure right now. They also recommend that cautious investors shift their equity holdings into call options on the S&P 500 as a way to participate in further upside while capping the downside. They also recommend using a bear put spread options strategy on high yield debt as a hedge, Bloomberg indicates. (For more, see also: Stock Investors' Handbook for a Bear Market.)

The Economics of Scarcity

Meanwhile, publicly-traded stocks are becoming an increasingly scarce commodity, driving equity prices upward for this reason alone, the Financial Times reports. Share repurchases by U.S. corporations since the financial crisis have added up to a staggering figure of nearly $5 trillion, per the FT. According to research by S&P Global, the number of shares outstanding from S&P 500 companies is about the same as it was a decade ago, even as the index has almost doubled in value.

Another factor driving scarcity is the growth of passive investing in index funds and ETFs​, the FT adds, citing analysis by Christopher Harvey at Wells Fargo & Co. (WFCWFCWells Fargo & Co54.24+0.92%). As these funds grow in size, they need to buy more of the equities in the market indexes that they track, removing yet more shares from general circulation. This only adds to the scarcity of equity shares in the open market, propping up their prices. Harvey sees a parallel with quantitative easing by central banks, which took government bonds out of the open market, thereby boosting their prices. (For more, see also: The Incredible Shrinking Stock Market.)