Morgan Stanley strategists warn S&P 500 overvalued by 10%, Fed rate cuts unlikely to solve stock market woes

Michael Wilson, chief information officer and chief US equity strategist at Morgan Stanley, has his views on the market outlook. He said that the market may remain vulnerable in the near term until it gets more positive data on the economy or the Fed provides more support on policy, but he expects neither to happen quickly. He thinks the market may get some support from the low valuations but that current prices do not reflect that. The S&P 500 is trading at 20 times forward 12-month earnings estimates. He noted that, assuming a soft landing for the economy, the multiple is close to 19 times, which means that stocks are not cheap until they get to 17-18 times, which is more than 10 per cent higher than the current trading price.

Wilson further analyzed that the process of forming a market top began in April, which was the first major sell-off since last October. Although many stocks and indices have hit new highs this summer, the market leadership has taken on a more defensive posture, with utilities, staples and real estate outperforming the past few years.

The rotation of market leaders coincided with the soft second-quarter economic data and has continued into the summer, with key labor market data also joining the trend. The rotation of market style is an early warning signal that the stock market may be vulnerable to a correction, as Wilson emphasized in early July.

Wilson also noted that the third quarter is often a time of seasonal market adjustment. Valuations have reached very high levels this year, which is also why there is little room for the US stock market to rise next year even if the economists’ basic prediction of a soft landing for the economy is correct.

The deterioration of economic data, coupled with the Fed not being in a hurry to cut rates, has created a double challenge for the market. The Fed tends to focus on the two-year Treasury yield, and in the past month, the two-year yield has fallen 100 basis points, almost 170 basis points below the Fed funds rate. That means the market is telling the Fed that their policy is too restrictive and they need to cut rates more than they are guiding for.

Wilson said the Fed’s dilemma is that the next meeting is six weeks away, which feels like a long time in the current market environment. The market is often impatient, so he expects the market to remain in a high-volatility state until the Fed meets the market’s expectations. Of course, the other side is the Fed cutting rates during the meeting, but Wilson thinks that may exacerbate concerns about the economy.