By Michael Wilson, chief US equity strategist at Morgan Stanley
Growth Risks Still Not Priced
Over time, the lion’s share of stock returns is determined by earnings growth if one assumes that valuations are relatively stable. However, they are far from stable and often hard to predict. In my experience, most investors don’t spend nearly as much time trying to predict multiples as they do earnings. This is probably because it’s hard to do consistently and there are so many methodologies it’s often difficult to know if you are using the right one. For equity strategists, predicting valuations is core to the job and so we spend a lot of time on it.
Our methodology is fairly simple, which doesn’t make it right but does make it easy to determine what kind of bet one is making. There are just two components – 10-year Treasury yields and the equity risk premium (ERP). At any given time, the P/E ratio and 10-year Treasury yields are observable from market prices. The equity risk premium is therefore just a plug based on those independent variables, making it relatively volatile. Year to date, the biggest driver of stocks has been the de-rating in valuations. To illustrate this point, the S&P 500 P/E has fallen approximately 20% while the price has fallen only 15%. At the lows just a few weeks ago, the P/E was down close to 24% when the index was down 20%. At that point, the P/E was 16x, right in line with our de-rating forecast for this year but above our current fair value multiple of 14.6x, which assumes an ERP of 370bp and a 10-year Treasury yield of 3.15%.
As noted above, predicting the right multiple for stocks may be one of the hardest things to do as an investor; however, there are times when the valuation gets so out of line the call is easier to make. For example, in March 2020, valuations collapsed as equity markets panicked about what the lockdowns and recession would do to growth and earnings. At the market’s low in 2020, the ERP reached nearly 700bp, a level we have surpassed only two other times in the past 30 years – during the global financial crisis in 2008 and in summer 2011, when US Treasury debt was downgraded. Both events were truly terrifying for investors but both also proved to be great buying opportunities. 2020 was another, and the 700bp ERP was the main reason why we flipped to bullish at the right time. Markets can always go lower in such circumstances, but cheap valuation provides the buffer against being wrong on timing.
At the end of last year, we had the opposite situation with the P/E at 21.5x. From our vantage point, both rates and ERP appeared to be mis-priced. Rates are obviously more levered to inflation expectations and Fed policy. At year-end, 10-year Treasuries did not properly reflect either risk. Today, we would argue that’s not the case. In fact, 10-year Treasuries may be pricing too much Fed tightening if growth continues to erode and recession risk becomes acute as Friday's consumer confidence number suggests.
In contrast to rates, the ERP is largely a reflection of growth expectations. When growth is accelerating/decelerating, the ERP tends to be lower/higher. At year-end, the ERP was 315bp, well below the average of the past 15 years. It was also below our estimate for the ERP of 335bp at the time. In short, the ERP was not reflecting the rising risks to growth in 2022 that we expected coming into this year. Fast forward to today, and the ERP is even lower at just 295bp, 75bp below our current estimate of fair value.
Given the growing evidence of slowing growth and the risk to earnings, that estimate could even rise further and is why we think the S&P 500 is headed toward 3,400 before a more tradable low is in.
With growth now the main risk to stocks, our focus remains on names that can deliver on earnings in a very difficult environment for many companies to navigate. In short, it is still the year of the stock picker as the index remains challenged. We continue to like classic late-cycle winners – defensives and energy – and companies with high operational efficiency.