The stock market’s summer rally has a shaky foundation, and investors should shift back to a more defensive stance, according to Morgan Stanley. Strategist Mike Wilson said in a note to clients on Monday that the recent rally, which has the S & P 500 up roughly 17% from its June lows, has priced in too much optimism about the path of the U.S. economy and the Federal Reserve. “The equity market has front-run a durable Fed pause, the odds of which are low to begin with. This leaves valuation significantly disconnected from economic/earnings reality. Risk/reward remains unattractive,” Wilson wrote. If the market rally reverses, disappointing earnings are a likely catalyst, according to Morgan Stanley. “While many focused on the impact of the recent jobs and CPI prints from a Fed policy standpoint, we came away with some fundamental takeaways as well. The combination of sustained, higher wage costs and slowing end market/consumer pricing loudly signals margin pressure,” Wilson wrote. To protect portfolios, Morgan Stanley recommended a list of stocks with quality and defensive characteristics. The stocks below have an overweight rating from a Morgan Stanley research analyst and are classified as both a quality and defensive stock based on the firm’s quantitative framework. Some of the stocks on the list are names that outperformed early in the year, when the market was declining. Shares of PepsiCo , for example, are up about 3% for the year but have underperformed the S & P 500 since mid June. Lockheed Martin has surged 23% in 2022 but has also lagged the market during the summer. UnitedHealth has kept better pace with the market in recent months and is now up 8% for the year. Health-care stocks like United are generally seen as defensive because their revenues are more resilient during economic downturns. One stock on the list that has underperformed the market this year is Lowe’s . The home improvement retailer is set to report its second-quarter results on Wednesday. In the first quarter, Lowe’s missed revenue estimates but it did keep its full-year outlook, suggesting that the retailer was confident in its business through the summer. — CNBC’s Michael Bloom contributed to this report.
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