S&P 500: New bull market outruns real improvements in US economy and equity fundamentals – Morgan Stanley

After hitting a record high of 3380 on 19 February, then plunging 34% to a pandemic-induced low of 2237 on Mar 23, the S&P 500 index took just five months to make a round trip and set a new record. Nevertheless, the recovery stage of this new business cycle has not transitioned to an expansion phase for three reasons explained by Lisa Shalett from Morgan Stanley.

Key quotes

“S&P 500 gains are concentrated in a handful of stocks. The five largest names, mostly tech and social media companies, now comprise a historic 25% of the index. That group is up 30% year to date, but the median stock is down 7%. The result is an index that is not only expensive – the forward price-earnings (P/E) ratio is 23, near the extremes of the 1999 tech bubble – but also very top-heavy. Lower interest rates may seem to justify high valuations, but if inflation picks up as the recovery progresses, those rates will likely rise and create market headwinds.”

“The market seems disconnected from the economy. While markets tend to anticipate the future, expectations may be getting unrealistic. We see lots of data supporting a V-shaped recovery but the recession isn’t over. Unemployment remains over 10%; even a 20% jump in GDP growth in the third quarter would return the economy to a level still 9% below where it stood in January. We don’t expect GDP to fully recover until the second quarter of next year and doubt that corporate profits will significantly outpace that rate.”

“Investors seem overly complacent about potential risks. Individual investors seem somewhat subdued, but institutional investors have moved to max-bullish sentiment, with put/call ratios at seven-year lows (a low number indicates investors expect stocks to rise). Such complacency seems odd, given high uncertainty about the next phase of fiscal stimulus. Although the outlook may have improved on COVID-19 infection rates and a vaccine, the pandemic’s trajectory remains in doubt. The US presidential election, where possible outcomes are very much in flux, represents another major unknown for markets.”

“We expect markets to be mostly range-bound over the next three months of uncertainty and think small caps, value-style and cyclical stocks will return to favor. Meantime, watch market breadth, valuations and economic fundamentals for signs that the market is reaching new extremes.”