How Valuation Should Determine Strategy Going Forward

While the Fed navigates a soft landing for the U.S. economy and stock valuations remain high, how can investors navigate the risks and rewards of a surprisingly strong equity market? Lisa Shalett is Morgan Stanley Wealth Management’s Chief Investment Officer. She is not a member of Morgan Stanley Research.

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Andrew Sheets: Welcome to Thoughts in the Market. I'm Andrew Sheets, Fixed Income Strategist at Morgan Stanley

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Lisa Shalett: And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management. 

Andrew Sheets: And today on the podcast, we'll be discussing what's been happening year to date in markets and what might lie ahead. It's Friday, August 11th at 1 p.m. in London. 

Lisa Shalett: And it's 8am here in New York City. 

Andrew Sheets: So, Lisa, it's great to have you here. I think it's safe to say that as a strategy group, we at Morgan Stanley have been cautious on this year. But I also think this is a pretty remarkable year. As you look back at your experience with investing, can you kind of help put 2023 in context of just how unusual and maybe surprising this year has been? 

Lisa Shalett: You know, I think one of the the key attributes of 2023 is, quite frankly, not only the extraordinarily low odds that history would put on the United States Federal Reserve being able to, quote unquote, thread the needle and deliver what appears to be an economic soft landing where the vast and most rapid increase in rates alongside quantitative tightening has exacted essentially no toll on the unemployment rate in the United States or, quite frankly, average economic vigor. United States GDP in the second quarter of this year looked to accelerate from the first quarter and came in at a real rate of 2.4%, which most folks would probably describe as average to slightly above average in terms of the long run real growth of the US economy over the last decade. So, you know, in many ways this was such a low odds event just from the jump. I think the second thing that has been perplexing is for folks that are deeply steeped in, kind of, traditional analytic frameworks and long run correlative and predictive variables, the degree to which the number of models have failed is, quite frankly,  the most profound in my career. So we've seen some real differences between how the S&P 500 has been valued, the multiple expansion that we have seen and things like real rates, real rates have traditionally pushed overall valuation multiples down. And that has not been the case. And, you know, I think markets always do, quote unquote climb the wall of worry. But I think as we, you know, get some distance from this period, I think we're also going to understand the unique backdrop against which this cycle is playing out and, you know, perhaps gaining a little bit more of an understanding around how did the crisis and the economic shocks of COVID change the labor markets perhaps permanently. How did the degree to which stimulus came into the system create a sequencing, if you will, between the manufacturing side of the economy and the services side of the economy that has created what we might call rolling slowdowns or rolling recessions, that when mathematically summed together obscure some of those trends and absorb them and kind of create a flat, flattish, or soft landing as we've experienced. 

Andrew Sheets: How are you thinking about the valuation picture in the market right now? And then I kind of want to get your thoughts about how you think valuations should determine strategy going forward. 

Lisa Shalett: So this is a fantastic question because, you know, very often I'm sitting in front of clients who are, you know, very anxious about the next quarter, the next year. And while I think you and I can agree that there certainly are these anomalous periods where valuations do appear to be disconnecting from both interest rates and even earnings trends, they don't tend to be persistent states. And so when we look at current valuations just in the United States, if you said you're looking at a market that is trading at 20x earnings the implication is that the earnings yield or your earnings return from that investment is estimated at roughly 5%. In a world where fixed income instruments and credit instruments are delivering that plus at historic volatilities that are potentially half or even a third of what equities are, you can kind of make the argument that on a sharp ratio basis, stocks don't look great. Now, that's not all stocks. Clearly, all stocks are not selling at 20x forward multiples. But the point is we do have to think about valuation because in the long run, it does matter. 

Andrew Sheets: I guess looking ahead, as you think about the more highly valued parts of the market, where do you think that thinking might most likely apply, as in the current valuation, even if it looks expensive, might be more defendable? And where would you be most concerned? 

Lisa Shalett: I think we have to, you know, take a step back and think about where some of the richest valuations are sitting. And they're sitting in, you know, some of the megacap consumer tech companies that have really dominated the cycle over the last, you know, 14, 15 years. So we have to think about a couple of things. The first is we have to think about, you know, the law of large numbers and how hard it is, as companies get bigger and bigger, for them to sustain the growth rates that they have. There will never be companies as dominant as, you know, certain banks. There will never be companies that are as dominant as the industrials. There will never be companies that are as dominant as health care. I mean, there's always this view that winners who achieve this kind of incumbent status are incumbent forever. And yet history radically dispels that notion, right? I think the second thing that we need to understand is very often when you get these type of valuations on megacap companies, they become, you know, the increased subject of government and regulatory scrutiny, not only for their market power and their dominance, but quite frankly for things around their pricing power, etc. The last thing that I would say is that, you know, what's unique about some of the megacap consumer tech companies today that I don't hear anyone talking about, is this idea that increasingly they're bumping up against each other. It's one thing when, you know, you are an e-commerce innovator who is rolling up retail against smaller, fragmented operators. It's quite another when it's, you know, three companies own the cloud, seven companies own streaming. And I don't hear anyone really talking about it head on. It's as if these markets grow inexorably and there's, you know, room for everyone to gain share. And I push back on some of those notions.

Andrew Sheets: So, Lisa, I'd like to ask you in closing about what we think investors should do going forward. And to start, within one's equity portfolio, where do you currently see the better risk reward? 

Lisa Shalett: So we're looking at where are the areas where earnings have the potential to surprise on the upside, and where perhaps the multiples are a little bit more forgiving. So where are we finding some of that? Number one, we're finding it in energy right now. I think while there's been a lot of high fiving and enthusiasm around the degree to which headline inflation has been tamed, I think that if you, you know, kind of look underneath the surface, dynamics for supply and demand in the energy complex are beginning to stabilize and may in fact be showing some strength, especially if the global economy is stronger in 2024. A second area is in some of the large cap financials. I think that some of the large cap financials are underestimated for not only their diversity, but their ability to actually have some leverage if in fact global growth is somewhat stronger. We also think that there may be opportunities in things like residential REITs. There's been, you know, concern about that area, but we also know that the supply demand dynamics in US housing are in fact quite different this cycle. And last but certainly not least, I think that there are a series of themes around fiscal spending, around infrastructure, around decarbonization, around some of the the reconfiguration of supply chains that involves some of the less glamorous parts of the market, like utilities, like, you know, some of the industrials companies that have some very interesting potential growth attributes to them that that may not be fully priced as well. 

Andrew Sheets: Lisa, thanks for taking the time to talk.  

Lisa Shalett: Absolutely, Andrew. Always a pleasure. 

Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on Apple Podcasts. It helps more people find the show.