Our CIO and Chief US Equity Strategist explains how to make sense
of the equity market’s narrow performance, and why stock picking
takes on greater importance for investors.
----- 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 the narrowness in breadth and why that supports our
preference for high quality and defensive stocks.
It's Tuesday, June 25th at 11:30am in New York.
So let’s get after it.
I am fond of the saying that the economy is not the stock market,
and the stock market is not the economy. Often, a strong economy
is not good for stocks, while a soft one can lead to higher
equity prices. This latter case is the classic late cycle period
in which we find ourselves. More specifically, when the economy
is slowing from previous tightening by the Federal Reserve, the
equity market starts to get excited about the Fed reversing
course, and it looks forward to loosening policy and valuations
rise in anticipation. With price/earnings multiples and
other valuation metrics now in the top decile, the
question is when will valuations matter and begin to fall
faster than earnings growth and lead to a meaningful correction?
At the stock level, this is already happening as illustrated by
the weakest breadth since 1965. In other words, most stocks are
seeing valuations fall more than earnings are rising. This is
exactly why stock picking has become so important for equity
investors to outperform the S&P 500. While this creates a
great long and short opportunity, the list of longs has become
harder to find and why the momentum in a few stocks continues
unabated. This also syncs with our view for the past year that
large cap quality is likely to continue to outperform until
something material changes in the macro environment. I see three
potential candidates to change this seemingly very stable and
benign outcome for equity markets.
First, inflation and growth reaccelerate in a way that forces the
Fed to reconsider rate hikes. Right now, that does not appear
likely and why there is virtually no risk of such an outcome
priced into either bond or stock markets. Such an outcome would
likely lead to a broadening out of the equity rally to areas that
have lagged persistently over the past 2 years—areas like small
caps, lower quality consumer cyclicals, regional
banks and transports. The S&P 500 would likely
trade poorly under this scenario as higher rates would
potentially weigh on valuations for the big winners.
Second, the liquidity picture deteriorates and money flows out of
equities. A key risk in this regard relates to
the funding of the extraordinary government deficit. A good
way to monitor this risk is the term premium in the bond market
which remains near zero. Should this change and the term premium
rise like last fall, the decline in equities would likely be
broad with few stocks doing well. This does not appear to be a
concern at the moment given the liquidity provisions still in
place.
The third possible risk is a growth scare that is substantial
enough to turn bad economic data into bad news for equity
multiples across the board. This is the most likely risk to upset
the apple cart in our view. Under this outcome, large cap quality
should continue to do ok on a relative basis, but defensives are
likely to do better.
The economic growth surprises have been trending lower all year.
So far, the S&P 500 has taken these weaker data in stride
assuming bad economic data is still good for large cap quality
stocks as the market looks forward to rate cuts from the Fed.
Meanwhile, weaker indices and stocks have broken down with many
now down on the year.
The bottom line is that the ongoing policy mix of heavy fiscal
spending and tight interest rate policy is crowding out many
companies and consumers in a waythat is unsustainable in our
view. Investors have correctly recognized this outcome by bidding
up the few stocks of the companies that are doing well
in this environment. Until the bond market pushes back via
higher term premium or growth slows down in a more meaningful
way, we expect this narrow market performance to persist. As
such, we continue to recommend a barbell of large cap quality
growth with defensives while fading cyclicals and avoiding the
temptation to play for a true broadening out until the macro
regime makes a meaningful shift.
Thanks for listening. If you enjoy Thoughts on the Market, please
leave us a review wherever you listen and share the podcast with
a friend or colleague today.
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