Times to maintain caution: 3 reasons why US stock market investors must not get overconfident

Equity indices on Wall Street have been moving higher since the US Federal Reserve hikes interest rates on March 16. The S&P 500 has gained 4%, NASDAQ is up nearly 6%, and the Dow Jones is up 2%. “These developments indicate markets may be counting on a “Goldilocks” scenario, where policymakers tame inflation with limited damage to economic growth and keep long-term rates low by historical standards,” said Lisa Shalett, Chief Investment Officer, Morgan Stanley Wealth Management. She added that there are reasons to believe that the confidence investors are showing right now may not be warranted.

Stocks overvalued: Lisa Shalett said that at this juncture earnings yields are low and price/earnings ratios are high relative to historical trends when considering prior periods of higher-than-expected inflation. “Specifically, over the past 70 years or so, when the Consumer Price Index ran between 6% and 8%, S&P 500 price/earnings ratios averaged about 12. Today, that multiple is about 20,” she added. The return premium for taking risk by investing in equity is also seen to be low right now.

Since the pandemic began, NASDAQ and S&P 500 have nearly doubled and Dow Jones is up 80% pushing valuations higher.

Fed may be ill-prepared: Hiking interest rates and withdrawing liquidity from the market is on the cards for the US Fed and all eyes are glued to how the US central bank will do so. However, the Fed has so far not announced details of any such plans. “Consensus expectations say the Fed will drain at least $560 billion over the rest of 2022, an action that would be equivalent to another quarter-percentage-point rate hike. As we have commented before, the Fed has limited experience with these operations and execution risk is high,” Lisa Shalett said.

50 bps could be on the cards: Lastly, Shalett said that markets may be inferring that the US Fed would step in if equity indices decline sharply. This hope may be misplaced, given the Fed’s recent hawkish rhetoric, with governors acknowledging a need to move more aggressively on tightening, including the possibility of half-point rate hikes, as opposed to the typical quarter-point ones,” she added. Economics at Morgan Stanley are now projecting a 50 basis point hike in rates. 

Morgan Stanley analysts are projecting a bumpy ride for investors rather than a short and sweet rate hike cycle. Amid this, analysts are advising investors to consider using rallies to take profits in passive indices and redeploy assets toward active managers. 

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