From Michael Wilson, Morgan Stanley chief US equity strategist
With just one week to go until the US elections, the outcome remains uncertain. It’s also holding up the next round of fiscal stimulus. This political uncertainty along with the arrival of the second wave of COVID-19 has pushed equity volatility higher and the S&P 500 hasn’t been able to make a new closing high in eight weeks, the longest period since the new bull market began in March.
From a technical perspective, I have been watching a key resistance area for the S&P 500 since early September that comes in around 3550.
Two weeks ago, the index failed to break through that level for the second time. This technical failure is not the end of the bull market, but it does suggest that this level of resistance is formidable and will be difficult to surmount in the near term. On the downside, I continue to like the 200-day moving average, which comes in around 3125. Bottom line, from a technical perspective I stick with our call from early September that the S&P 500 will be range-bound between 3100 and 3550 into November.
From a valuation perspective, the S&P 500 is trading at an equity risk premium of 380bp. That’s a fair but full level based on the current realized equity volatility.
However, with so much uncertainty surrounding the outcome of the US elections, the second wave of COVID-19, and the upward pressure on long-term interest rates and volatility, the equity risk premium should be about 10% higher, in my view. In short, we like our 3100-3550 range on the S&P 500 as a good guide for US equity risk-taking from both a technical and valuation perspective.
Beyond this simple trading range view for the S&P 500, there is a more important opportunity for investors to consider. With the re-valuation of equities largely over at this point, we believe that investors should favor companies that can deliver higher earnings growth than what’s already priced. While many seem to favor companies that have been able to operate normally during this pandemic and take share, this may not be the best investment strategy from here. Essential businesses/services or digital transformation enablers have been spectacular performers this year, but this just means that expectations are high and comparisons difficult. Furthermore, there is likely to be some payback on demand and loss of wallet share next year for such companies. In contrast, businesses and services that have not been able to operate normally may provide better investments at this time primarily because expectations remain low and wallet share gains are likely.
Investors need to be selective of course because many of these companies that are not able to operate normally today may never recover, at least not fully. One thing that is certain about this pandemic is that many things we used to take for granted are likely to be different going forward. However, many things will return to exactly the way they were before and experience pent-up demand next year. Secondarily, there are changes afoot that will require significant investment as the world demands better and safer ways of doing things. One such area is infrastructure, where the world has underinvested for years, especially in the United States. With central banks willing and able to finance such a popular endeavor, we think that this is one very attractive investment opportunity today.
This would favor companies in the industrial and materials sectors, particularly base metals like copper. We also think that there could be pockets of acute inflation next year as demand comes roaring back to the parts of the economy where supply has been destroyed. This means higher long-term interest rates even if the Fed remains on hold with overnight rates. While that is a headwind for fixed income investments and stocks levered to lower interest rates, it’s also a tailwind for stocks levered to higher rates, which includes those same infrastructure beneficiaries as well as financials and other cyclicals.
Bottom line, we expect the S&P index to remain range-bound in the near term, with more downside than upside from current levels. We recommend taking advantage of any near-term correction in the headline index to add to investments in areas that are likely to be the biggest beneficiaries of the economy reopening further next year. In short, the bull market is intact as it broadens out to smaller, more cyclical parts of the market – a strategy we’ve advocated since April but one that is still underappreciated and in its early days in terms of its upside potential.