Wall Street equity indices scaled fresh highs in August, without the backing of any economic or profit fundamental, said Lisa Shalett, Chief Investment Officer, Morgan Stanley Wealth Management while adding that this up-move has pushed US stocks into the overpriced zone. Looking ahead, Shalett added that two factors could now serve as catalysts for a near-term pullback in stock indices. The NASDAQ gained 4% during the previous month while S&P 500 jumped 2.9% and Dow Jones inched 1.9% higher. The three benchmark indices scaled all-time highs in August.
According to Lisa Shalett, US stock market investors have ignored numerous risk factors, including the resurgence of Covid-19 hospitalizations in the US, falling consumer confidence, higher interest rates and significant shifts in geopolitics in China and the Middle East. This has largely been led by the US Fed’s efforts to successfully convince investors that it is in rush to increase rates.
The first of the two catalysts seen by Morgan Stanley Wealth’s CIO is interest rates, which she said could rise. “We see real rates rising, not only as the Fed is expected to start reducing its bond purchases but also as global economies recover, which could encourage foreign investors who have flocked to Treasuries as a “safe haven” to move their money elsewhere,” Shalett said.
If interest rates surge, it could impact the price-to-earnings multiple of stocks. Currently, P/E multiples of stocks are well above historic highs. Although small-capitalization stocks, cyclicals and dividend-payers have retreated from year-to-date highs but mega-capitalization technology leaders have not said Lisa Shalett.
Further, the second catalyst seen is the possibility of waning corporate earnings. “Year-to-date earnings have been spectacular—full-year 2021 earnings estimates are up by more than 20% from their levels at the start of the year. However, we are concerned about the sustainability of operating margins, given the headwinds to corporate profitability: higher taxes, more aggressive regulation, higher input costs, higher cost of labour and a weaker U.S. dollar,” Lisa Shalett said.
These two factors could fuel a near-term market correction. “Such a breather could help restore risk premiums and preserve potential returns for the selective stock picker,” Morgan Stanley Wealth’s CIO said. To prepare for the said catalysts, Lisa Shalett advises investors to rebalance their portfolios towards high-quality cyclical stocks, as well as dividend-paying names in consumer staples, consumer services and health care.