Morgan Stanley
  • Wealth Management
  • Nov 25, 2019

Are U.S. Investors Wearing Rose-Colored Glasses?

Elevated stock prices reflect confidence that U.S. economic growth and consumer spending will continue to improve. That may not happen.

Lisa Shalett Chief Investment Officer, Wealth Management

It can be easy to confuse strong stock market performance with a vibrant economy and robust corporate profits. In the case of this year’s 26% climb in the S&P 500, those high returns seem particularly deceiving. 

This year’s gains have been driven mainly by Fed rate cuts and expectations for improvement in trade tensions, not strong economic growth. In fact, U.S. GDP growth is slowing, manufacturing is in recession and corporate profits are in decline. U.S. stocks now look very expensive relative to earnings. The price/earnings multiple of the S&P 500, a key measure of valuation, is now 18.7, up from 14.5 a year ago. In the last 40 years, it has only been that high about 25% of the time.

I think investors may be overly optimistic that a number of economic measures will keep improving. Below are three areas where there seems to be a growing wedge between reality and investor expectations:

  • Economic indicators are worsening in the U.S. While global numbers have improved, U.S. based measures of industrial production, capital spending, inventories and retails sales have not only been down recently, but by more than economists forecast. Surveys by regional Federal Reserve banks show business confidence is flagging.

  • The U.S. consumer may not be as strong as expected. Consumer confidence may be peaking while credit card spending is shrinking—a sign that consumers are tapped out, despite low interest rates. Uncertainty around the Presidential election could hurt confidence going forward. Can consumer spending really remain immune to declining corporate confidence and profits? I am doubtful.

  • The labor market could weaken. The biggest threat to consumer spending is typically a weaker labor market. That could happen if companies respond to slower revenue growth and shrinking profits by cutting jobs. Weekly initial jobless claims have started to inch up. Hiring may have peaked.

With the odds of disappointment rising while stock valuations are high, I think U.S. markets are vulnerable. Under these circumstances, I recommend investors diversify into sectors and regions that aren’t so expensive.

As year-end approaches, consider taking profits in U.S. winners and rotating into non-U.S. markets, financials, commodities and actively-managed funds that use strategies that may have positive returns, even if the S&P 500 does not.

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. 

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

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