After nearly 30 years of working on Wall Street, I am well acquainted with the fact that markets have a way of humbling investors. Arguably, some of the most humbling moments occur when circumstances change, and investors must shift perspectives accordingly. This lesson has been particularly relevant in observing the recent surge in the S&P 500 Index over the last several months—and it’s a lesson that many investors seem to have overlooked.
The benchmark U.S. equity index has been on a tear, notching gains in 16 of the last 17 weeks. But even more remarkable than the index’s 24% surge since last fall is the fact that investors have stayed almost unfailingly optimistic, without appearing to pause for doubt or reflection along the way, even as circumstances have changed.
Coming off the market’s lows in October 2023, investors were confident that interest rates had peaked and the Federal Reserve was about to cut them as many as seven times by January 2025. However, when recent data showed hotter-than-expected economic growth and a pickup in inflation, investors remained bullish. They simply shifted the narrative, indicating their belief that a reaccelerating economy and strong company profits will lift markets. But analysts have continued to negatively revise company earnings estimates for this year and next, and the market’s strength has remained concentrated in only a narrow group of mega-cap stocks.
If lower rates are not on the immediate horizon and earnings fundamentals may be at risk, what is driving the buoyant stock market? Morgan Stanley’s Global Investment Committee sees two key factors.
- Liquidity: Financial conditions have become looser than they were even before the Fed started raising rates in March 2022. Ample injections of cash into the financial system from banks, money markets and government stimulus programs have more than offset the Fed’s tightening of monetary policy. Importantly, however, these sources of financial liquidity may finally be drying up, as excess savings cushions are nearing exhaustion.
- Excitement about artificial intelligence: A recent report from Morgan Stanley Research showed that AI-driven productivity could add 30 basis points to next year’s net profit margins for S&P 500 companies. There’s particular opportunity for efficiency gains among services-oriented sectors and industries, such as software and services, consumer services and financial services. That said, we think these potential gains may already be priced in to stocks’ valuations, with current consensus estimates of $277 per share for S&P 500 earnings next year, an increase of 26% from current levels. On top of that, margins may come under pressure even as productivity improves, as a stronger U.S. dollar, higher costs from interest rates and input inflation could end up offsetting such gains.
How to Invest
Amid these shifting market narratives, questions remain as to whether investors should be positioned defensively or offensively, or if they should simply hide behind the mega-cap growth stocks.
At a time when both exuberance and uncertainty are this high, the Global Investment Committee’s preference is to actively look for stocks and credit whose valuations are supported by solid fundamentals.
Consider seeking out value in U.S. equities, balancing any passive exposure to major market-cap-weighted indices with exposure to quality growth names in energy, utilities, materials, financials and health care. These areas may present opportunities to hedge against excessive market optimism while providing exposure to growth themes beyond the companies that are enabling AI.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 4, 2024, “The Ever-Changing Bullish Narrative.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.
