A later cycle economy and continued uncertainty means that
investors should be remain wary of cyclicals such as small caps,
explains Mike Wilson, our CIO and Chief US Equity Strategist.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan
Stanley’s CIO and Chief US Equity Strategist. Along with my
colleagues bringing you a variety of perspectives, today I'll
be talking about slowing growth in the context of high
valuations.
It's Tuesday, July 30th at 3pm in New York.
So, let’s get after it.
Over the past few weeks, the equity markets have taken on a
different complexion with the mega cap stocks lagging and lower
quality small caps doing better. What does this mean for investor
portfolios? And is the market telling us something about future
fundamentals? In our view, we think most of this rotation is due
to the de-grossing that is occurring within portfolios that are
overweight large cap quality growth and underweight lower quality
and smaller cap names.
We have long been in the camp that large cap quality has been the
place to be – for equity investors – as opposed to diving down
the quality and cap curves. That continues to be the case; though
we are watching the fundamental and technical backdrop for small
caps closely, and we’re respectful of the pace of the recent move
in the space.
For now, however, we continue to think the better risk/reward is
to stay up the quality curve and avoid the more cyclical parts in
the market like small caps. Our rationale for
such positioning is simple — in a later cycle economy where
growth is softening or not translating into earnings growth
for most companies, large cap quality outperforms.
Exacerbating the many imbalances across the economy is a bloated
fiscal budget deficit. In our view, there are diminishing returns
to fiscal spending when it starts to crowd out private companies
and consumers. As I have been
discussing for the past year, this crowding out has contributed
to the bifurcation of performance in both the economy and
equity markets, while potentially keeping the Fed's Interest rate
policy tighter than it would have been otherwise.
While the macro data has been mixed, there is a growing debate
around the actual strength of the labor market with the household
survey painting a weaker picture than the non-farm payroll data
which is based on employer surveys. The bottom line is that we
are in a stable, but decelerating late cycle economy from a macro
data standpoint. However, on the micro front, the data has not
been as stable and is showing a more meaningful deterioration in
growth; particularly as it relates to the consumer.
More specifically, earnings revision breadth has broken down
recently for many of the cyclical parts of the
market. Financials has been a bright spot
here but that may be short-lived if the consumer continues
to weaken. We continue to favor quality but with a greater focus
on defensive sectors like utilities, staples and REITs as opposed
to growthier ones like technology. The issue with the growth
stocks is valuations and the quality of the earnings for
some of the mega cap tech stocks.
The other variable weighing on stocks at the moment is valuations
which remain in the top decile of the past 20 years. It’s
worth noting that valuations are very sensitive to
earnings revisions breadth. The last time revision breadth
rolled over into negative territory was last fall. Between
July and October 2023, the market multiple declined from 20x to
17x. Two weeks ago, this multiple was 22x and is now 21x. If
earnings revisions continue to fade as we expect, it’s likely
these valuations have further to fall. With our 12-month
base case target multiple at 19x, the risk reward for equities
broadly remains quite unfavorable at the moment.
Thanks for listening. If you enjoy the podcast, leave us a review
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friend or colleague today.
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