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3 Alternatives to U.S. Stocks in a Fragile Market

Jun 6, 2023

As risks linger in U.S. markets, investors may find opportunities in Japanese equities, emerging-market stocks and commodities.

Lisa Shalett

Key Takeaways

  • Investors may want to look beyond the U.S. stock market for opportunities to diversify their portfolios and manage risk.
  • Japanese stocks could benefit from resurgent growth, manageable inflation and favorable trade dynamics.
  • Emerging-market equities also look inexpensive and could benefit from China’s robust economy and a weaker U.S. dollar.
  • A potential rebound in economically sensitive commodities markets could bolster stocks in energy, industrials and real estate.

It’s easy to see why some investors believe a new bull market is underway. The S&P 500 Index has gained 12% for the year to date, and the tech-heavy NASDAQ is up 27%. Meanwhile, the latest breakthroughs in artificial intelligence have generated exuberance for investors.


However, a handful of high-flying mega-cap tech stocks are dominating the benchmark indices, resulting in extreme concentration that we believe is masking two key risks in the U.S. stock market:


  • High valuations: The tech sector, which has driven much of the S&P 500’s performance lately, is looking increasingly expensive. The sector’s price-to-earnings (P/E) ratio has ballooned to about 29, up 46% from its January level. The 10 largest tech stocks have an even higher average P/E ratio of 39. That compares with the non-tech average of about 16. Such rich valuations depend on low interest rates and thus leave tech stocks vulnerable as persistent inflation prompts the Federal Reserve to keep rates higher for longer.
  • High expectations: For top tech stocks, year-over-year earnings are down about 17% from a year earlier. Yet markets seem to expect a big reversal of fortune for those companies, forecasting earnings growth of 27% in the next 12 months. This gap between recent earnings results and forward-looking estimates has never been wider. By comparison, earnings expectations for the rest of the index amount to just 1.5% growth.


These dynamics around concentration and lack of diversification are exacerbating market fragility and presenting risks for investors whose portfolios have significant passive exposure to benchmark U.S. stock indices. But three opportunities could offer prudent portfolio diversification:


  • Japanese equities recently rose to their highest levels in 33 years and may see further gains. Japan appears to have finally hit a sweet spot, with the momentum of a delayed post-COVID re-opening coinciding with structural reforms meant to stimulate the economy. After many years of crippling deflation, the country is also finally seeing some positive, but not unhealthy, levels of inflation, and shifting geopolitics may contribute to more favorable global trade dynamics for Japan. Equity-market valuations are attractive, with average P/E multiples in the 13-to-14 range.
  • Emerging-market stocks may also present an opportunity. Although China may not see any incremental stimulus, the country’s inflation is well-controlled, housing-related issues are easing and consumption continues to recover. Economic growth in China could boost the country’s key emerging-market trading partners, which may further benefit from potential weakening in the U.S. dollar. Emerging market equity multiples are attractive at a P/E ratio of nearly 12.
  • Commodities may provide a hedge in portfolios, offsetting potential decreases in U.S. equities. The broad-based S&P GSCI commodity index recently hit a one-year low, and economically sensitive commodities, in particular, appear poised for a price bounce. We expect rebounds in areas like copper and oil, which could support stocks in areas such as energy, industrials and real estate.


Concentrated gains in equities and rich valuations are not the stuff of new bull markets. In the spirit of prudent risk management, consider the above opportunities as you rebalance your portfolio, using tax-loss harvesting to neutralize extreme divergences in the performance of different holdings.


This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 5, 2023, “Time to Rebalance.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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