S&P 500 upside capped from current levels; Morgan Stanley says valuations remain high

By: |
May 19, 2021 3:08 PM

Now, as the US economy attempts to leap back to the old normal, earnings expectations are catching up. Companies are turning profitable, helped by the policy support extended amid the pandemic.

Wall streetWith the upside capped, Morgan Stanley believes investors should focus on reflationary beneficiaries like Financials and Materials. (Image: REUTERS)

With the S&P 500 index already above Morgan Stanley’s year-end target of 3,900, the global brokerage and research firm believes there’s no room left for the index to rise further. “We continue to believe valuations are too high and will adjust materially lower over the next six months,” Mike Wilson, Chief Investment Officer and Chief US Equity Strategist for Morgan Stanley said in a podcast. S&P 500 closed at 4,127 on Tuesday. So far this year the index has managed to jump nearly 12%.

“The primary reason we think valuation will prove to be a headwind, in our view, is we’ve left the early cycle part of this recovery,” Mike Wilson said. He added that valuations are high as we enter the mid-cycle transition phase. During this phase, Wilson added that the price to earnings multiple for the S&P 500 falls by approximately 20%. The same is down just 5% so far. Further, the uptick in long-term interest rates are also among the factors that are expected to limit the upside. While interest rates are up the most expensive and speculative parts of the equity market have de-rated significantly. “That tells us the de-rating is well underway and will eventually drive the multiple for the S&P 500 down by another 10-15%,” Mike Wilson added.

Now, as the US economy attempts to leap back to the old normal, earnings expectations are catching up. Companies are turning profitable, helped by the policy support extended amid the pandemic. “But now the reopening of the economy is likely to put upward pressure on costs and downward pressure on margins. This will come as a surprise to now lofty earnings estimates, in our view,” the US equity strategist said. This will be further impacted by the expected increase in corporate taxes, as proposed by the current Joe Biden administration. Morgan Stanley expects a change in corporate taxes to negatively affect S&P 500 earnings estimates for next year by approximately 5%.

With the upside capped, Morgan Stanley believes investors should focus on reflationary beneficiaries like Financials and Materials, rather than reopening plays like consumer discretionary stocks that carry high execution and margin risk. “We also favour quality stocks with relatively stable earnings, like consumer staples, which tend to do better during mid-cycle transitions. Similarly, reasonably priced growth stocks offer dependable performance in a mid-cycle transition period. In that regard, look toward Health Care and parts of Communication Services rather than Technology, where valuations remain rich, and payback in demand from last year remains underappreciated,” they added. The brokerage firm has now downgraded Industrials to equal weight and closed its underweight on small caps after a rather large 12% underperformance over the past two months.

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