Stocks could drop 20% or more: Morgan Stanley

The bank's strategists say stocks are facing potential 'fire' and 'ice' scenarios

The chances of a 20% or greater pullback in the S&P 500 are becoming more likely, according to Morgan Stanley. 

Strategists at the firm say there is growing evidence that the U.S. economy is slowing and that consumer confidence is waning. They laid out two near-term paths for stocks – the "fire" and "ice" scenarios. 

The "fire" scenario, which would result in a 10% correction, would occur should the Federal Reserve begin to remove monetary accommodation in response to an overheating economy, the strategists said.

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The "ice" scenario would be caused by earnings revisions and a deceleration in macro data points due to demand pull forward, supply chain issues and margin pressures, and generate a 20% or greater drop in the S&P 500. 

Ticker Security Last Change Change %
SP500 S&P 500 4566.48 +21.58 +0.47%

"The ‘ice’ scenario is starting to look more likely," wrote Morgan Stanley strategists led by Michael Wilson. 

The warning from Morgan Stanley comes as global markets were hammered Monday amid concerns that problems in China’s property sector could cause contagion all over the world.  

Should the "ice" scenario play out, it would be the first bear market for the S&P 500 since the index plunged 34% from Feb. 19, 2020, through March 23, 2020, as COVID-19 resulted in the sharpest economic slowdown of the post-World War II-era. 

The index had soared by as much as 102% off its pandemic low through Sept. 2 as investors celebrated the reopening of the global economy.

The unprecedented gains recently caught the attention of Wall Street, where strategists at Goldman Sachs Group Inc., Bank of America Corp., Citigroup Inc. and elsewhere warned about the potential for a stock market selloff. 

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The Morgan Stanley strategists say investors should take a defensive posture in high-quality health care and consumer staples companies while also maintaining some exposure to financials to be protected against a possible rise in interest rates.