US Equity Valuations At ‘Death Zone,’ S&P 500 Might Fall By 25 Percent: Morgan Stanley Strategist

Traders work on the trading floor at the New York Stock Exchange (NYSE) in New York on Jan. 5, 2023. (Andrew Kelly/Reuters)

Michael Wilson, chief U.S. equity strategist at Morgan Stanley, is warning that stocks are currently on the expensive side, with the risk-to-reward for equities “very poor” as he expects the S&P 500 index to tumble by 25 percent from current levels.

Wilson equated the current stock market valuations to a “death zone” in a note on Sunday, according to Business Insider. A death zone is a mountaineering term referring to altitudes beyond a certain point where the oxygen level is not sufficient to sustain human life for long. The sharp rally at the start of 2023 means that stocks are at their most expensive since 2007 by the measure of equity risk premium. They are now at a level Wilson calls the “death zone.”

The S&P 500 has risen by over 5 percent as of Feb. 21 year-to-date but is down by over 6.6 percent in the past one year. Wilson is expecting the S&P 500 to drop to 3,000 in the first half of 2023, which would represent a decline of 25 percent from the current level of just above 4,000.

“The bear market rally that began in October from reasonable prices and low expectations has morphed into a speculative frenzy based on a Fed pause/pivot that isn’t coming,” Wilson wrote.

“As [stocks] have reached even higher levels, there is now talk of a ‘no landing’ scenario—whatever that means … Such are the tricks the death zone plays on the mind—one starts to see and believe in things that don’t exist.”

The risk-to-reward for equities is now “very poor,” especially with high corporate earnings expectations, and the Fed not anywhere close to ending its monetary tightening policy, he noted.

Too Much Optimism

JP Morgan Chase has also issued a warning about significantly optimistic investors setting themselves up for disappointment within the present economic outlook.

Regarding the Federal Reserve’s interest rate hikes over the past year, a note by JP Morgan Chase said that the impact of monetary policy can have a lag of a year or two, due to which the investment firm believes it’s too early to call off a recession.

“Historically, equities do not typically bottom before the Fed is advanced with cutting, and we never saw a low before the Fed has even stopped hiking,” the strategists wrote on Monday, according to Bloomberg. “The damage has been done, and the fallout is likely still ahead of us.”

In its February 2023 meeting, the Fed had raised its benchmark interest rate to a range of 4.5 to 4.75 percent, up from around 0.25 percent in March 2022.

The central bank is waiting to bring inflation down to 2 percent. Since January 2022, the 12-month inflation has consistently remained above 6 percent for every single month.

Market Volatility, 10-Year Predictions

Financial services firm Fidelity is expecting market volatility to remain high this year, with the United States likely descending into a “mild recession.”

“At the start of 2023, the markets appear overly sanguine about how quickly and painlessly the Fed can pivot to easing monetary policy,” Fidelity said in a Jan. 23 post.

“Slower liquidity growth, persistent inflation risk, slowing growth momentum, and greater monetary policy uncertainty raise the odds that market volatility will remain elevated.”

Investment advisor Vanguard, one of the largest providers of ETFs (exchange-traded funds) in the world, has a tamer expectation of U.S. equity performance in the coming decade.

According to a Jan. 19 update, Vanguard predicts U.S. equities will only rise by 4.7 to 6.7 percent annually over a period of ten years. Since 1928, the S&P 500 has seen an annualized return of 9.3 percent.