(Bloomberg) — Stocks have rallied in the face of worsening earnings and economic expectations, producing “massive disconnects” that threaten market stability, warned Lisa Shalett at Morgan Stanley Wealth Management.Most Read from BloombergThe chief investment officer flagged a surge in economic-sensitive shares relative to defensive stocks as a sign of the market’s confidence in future growth. Yet indicators of retail sales, manufacturing and business leaders’ confidence have been weakening along with corporate earnings.The result, Shalett said in a note this week, is that the performance ratio of cyclical versus defensive stocks has never been as out of sync with the leading economic indicators as it is now.While the mismatch is increasingly framed as a sign that the market is predicting a soft landing for the economy despite the Federal Reserve’s ongoing tightening, Shalett is skeptical. She attributed the latest equity rally to potentially short-term technical factors, such as short sellers buying back stocks to cover bearish positions and the seasonal tendency of investors to flock to the market’s biggest losers from the previous year.In other words, a technical-driven rally has made the market deviate from the fundamentals.“I’ve heard the theories that people say, ‘yes, we understand what should happen, but we’re going look through it,’” Shalett said Wednesday on Bloomberg Television. “I don’t know how far their crystal ball goes to look through it, but history is not kind to these kind of massive disconnects.”Since the start of January, an index tracking cyclical shares has jumped 13%, compared with a decline of 2% from the defensive cohort. Meanwhile, analyst estimates for S&P 500 profit growth has turned negative, according to data compiled by Bloomberg Intelligence.Story continuesMoreover, the stock-market advance that has lifted the S&P 500 as much as 17% from its October low has contributed to an easing in financial conditions — a development that some see at odds with the central bank’s efforts to slow demand and curb inflation. The latest rush by investors into short-dated options is another sign that money is still easily available, Shalett said.While Fed Chair Jerome Powell has in recent weeks brushed off the market rally, Shalett warned that other policymakers may embrace tougher talk to put a lid on equity gains.“This use of options and this willingness to take these kind of very high turnover strategies, to me, that’s an indication that liquidity is at play, that market stability is going to once again raise its head as an issue,” she said. “If Chair Powell doesn’t want to talk about it, potentially some of the other governors who actually look at the data may start bringing it up.”–With assistance from Tom Keene and Jonathan Ferro.Most Read from Bloomberg Businessweek©2023 Bloomberg L.P.

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