Some of Wall Street's biggest firms are already waving red flags on the stock market's newest sector

trader biting nail nervous

On Friday, S&P Dow Jones Indices and MSCI flipped the switch on the new communication-services sector, which brings together telecom and some large internet companies.
At least four Wall Street firms are not bullish on the new sector, which is one of the market's worst performers this year.

The new communication-services sector implemented Friday is already getting sour reviews from some analysts at major Wall Street firms.

S&P Dow Jones Indices and MSCI first announced last November that they would discard the old telecom sector for a new one that melds communication and media companies. This was to catch up with the dealmaking that had created companies like Verizon that provide both.

Many investors who make sector-level decisions had already incorporated these business-model changes into their strategies. Also, many exchange-traded funds already allowed investors to buy in to some of the themes the reorganization aimed to capture.

But for anyone still making adjustments, analysts at major firms are urging caution. Here's what they're saying:

Morgan Stanley: Equal weight

The new sector is cheaper than the market average, as defined by its forward price-to-earnings ratio divided by the S&P 500's, according to Mike Wilson, Morgan Stanley's chief US equity strategist.

But this relatively attractive valuation still does not create a buying opportunity, he said. That's because investors cheapened stocks in the sector to reflect the disruption that was taking place.

"We would not classify this as a value sector though and think the message being sent is one of industry change as existing Media and Telco models shift, transform, and increasingly overlap in ever more congruent end markets," Wilson said in a client note on Monday.

"As secular champions like Netflix, Facebook, and Alphabet continue to grow into their multiples and structural changes continue, we are reluctant to rely on history to find the right multiple for this sector."

Wilson also said the sector's forward earnings growth relative to the broader market peaked in late 2016, and that helps explain its underperformance this year versus the S&P 500; it's down 3.6% and is the 10th-worst performer out of 11 sectors.

Screen Shot 2018 10 01 at 3.05.42 PM

Those are not the only reasons for caution: Wilson also pointed out the high concentration within the sector. Google and Facebook make up nearly half of its market cap, raising concerns about how effectively smaller companies can compete for advertising revenue.

"We think secular growers engender secular losers, particularly in an environment where overall spend is likely to decelerate with broader economic growth," Wilson said.

RBC Capital: Underweight

Lori Calvasina, RBC's head of US equity strategy, is even more bearish on the communication-services sector.

Calvasina noted a weak earnings profile, in that the momentum of earnings-per-share revisions has been negative and revenue beats slipped in the second quarter.

Like Wilson, she flagged the handful of tech stocks that dominate the sector. Her concern, however, is that some of these names like Facebook and Alphabet also have the most hedge fund dollars invested in them. They're also prominent on the list of companies with the largest overweights among large-cap-growth mutual funds.

The concern with crowding is that traders could experience painful losses if the majority view changes.

And with all the big-tech names in the sector, the threat of greater regulation also came up as a negative.

Bank of America Merrill Lynch: Underweight

Savita Subramanian urged investors to hold fewer stocks in this sector relative to the S&P 500, Bloomberg reported.

She added that if US economic growth broadened, investors could rotate out of crowded growth sectors and into less-populated areas that benefit from stronger gross domestic product.

She also cited regulation as a potential setback. On Friday, Facebook announced that a hacker gained access to nearly 50 million user accounts in one of the company's most significant cyberattacks. The hack drew attention to Facebook's data-collection and privacy practices because the breach exposed multiple other services that users log in to with Facebook.

Besides regulation, Subramanian said companies with high dividend yields could come under pressure as interest rates rise.

Wells Fargo: Unfavorable

"We have initiated guidance on the new communication services sector with an unfavorable rating," Scott Wren, a senior global equity strategist at Wells Fargo, said in a client note on Monday.

"As for the other two sectors involved in the GICS restructuring, we continue to rate the consumer discretionary sector as favorable and the IT sector as neutral."

The firm believes US stocks will continue rising on strong fundamentals but advised clients to look for "attractive opportunities that lie outside the US."

"Furthermore, because market downturns are often unexpected, we suggest holding asset classes that tend to do well when equity markets correct, such as high-quality bonds and hedge funds for qualified investors, consistent with an investor's risk tolerance."

Join the conversation about this story »

NOW WATCH: Why horseshoe crab blood is so expensive