The S&P 500 is vulnerable to a correction of up to 15% with tech-stock valuations at dot-com bubble levels, Morgan Stanley says

• The odds of a 15% stock market correction are rising, according to Morgan Stanley Wealth Management's Lisa Shalett.
• The CIO noted that technology stocks that dominate the S&P 500 are at levels not seen since the peak of the dot-com bubble.
• The tech sector's profitability and earnings are vulnerable and could pose a risk to the broader market, she said.
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The odds of a stock market correction of up to 15% are rising as lofty technology stock valuations leave the broader market vulnerable, according to Morgan Stanley Wealth Management's chief investment officer.

In a Monday note, Lisa Shalett highlighted how low rates have helped prop up tech stocks to dot-com era valuations. The price to sales ratio of the technology sector is at a level not seen since the peak of the dot-com bubble in 2000, she said.

In addition, the tech sector now makes up a much larger weight in the S&P 500 than in 2000, and has subsequently driven the price to sales ratio of the benchmark index to a level 50% higher than it has ever been.

"The problem with this setup is that tech sector profitability and earnings are vulnerable," said Shalett. "While secular growth trends may support resilience against small changes in economic growth, the sector now faces unprecedented headwinds from rising input costs, a weaker US dollar, fiercer competition, higher taxes, stricter regulations and customer backlash."

If those headwinds come to fruition for the technology sector, the broader market will be at risk.

She noted that markets tend to be strongest when they are broad based and there is a consensus narrative around what could go wrong in terms of economic outcomes, policy, geopolitics, and regulation.

"As we have noted for the past two months, the market continues to grind to all-time highs on narrowing breadth, while the narrative has also grown increasingly muddled. Thus, the risks of a correction are rising," she said.

The chief investment officer of wealth management told clients to focus on stock-picking using earnings fundamentals. She also said investors could consider adding to financials stocks as a value-oriented hedge to rising rates.