Seeing Through the Market’s Resilience

The S&P 500 Index touched a new record last week, as strong earnings reports helped erase a market swoon that began in September. And while nearly 90% of stocks in the index have declined at least 10% from their year-to-date highs, the index itself—increasingly dominated by a small group of mega-capitalization technology giants, with the top 15 names representing 40% of total market capitalization—has continued to prove resilient.

This brings us to revisit a call that Morgan Stanley’s Global Investment Committee made some months ago about a potential 10%-15% correction in the index.

We believe our call on the fundamentals has been on target. Inflation is proving more vexing, interest rates are rising, and the Federal Reserve’s move away from maximum accommodation is due to begin sooner than previously expected. So, why does the index remain elevated?

Key among the more plausible theories: retail investors could still be playing an outsized role in supporting the market, driven in part by a "fear of missing out" (FOMO) on the next big rally. These investors have been active stock-market participants since the start of the pandemic and seem committed to “buying the dip,” or purchasing securities at depressed prices based on the expectation that they’ll rise again. Since the pandemic began, retail daily net inflows have been averaging about $1 billion—three times the roughly $360 million average during 2018 and 2019. 

But individual investors may not have much firepower left. Morgan Stanley Chief Cross-Asset Strategist Andrew Sheets notes that after a historic surge in consumer savings earlier in the pandemic, the amount of cash on household balance sheets, as a percentage of total assets and net worth, is now back at levels consistent with averages since 1989. Sheets also notes that equity holdings—generally the most volatile asset that households own—are now at their all-time high as a percentage of household wealth. This means that while it’s still possible for people to put more money into the market, many may decide that they already have enough exposure at this point.

Although retail investors can still influence market dynamics, we continue to see various risks that the markets appear to underappreciate and that the FOMO urge is unlikely to resolve. In particular, investors should keep an eye on weakening market liquidity and tightening financial conditions. The Fed is likely to begin tapering its asset purchases, reducing the current monthly pace of $120 billion by $20 billion to $30 billion per month through next June. Additionally, the U.S. Treasury will be authorized to restart issuing debt following the lifting of the federal debt ceiling, which may drain as much as $720 billion from the system. Additional headwinds could include potential U.S. tax hikes and higher prices in energy, rent and re-opening services going into the holiday season.

Investors should resist the temptation to chase liquidity-driven stock indices at this point. Instead, consider focusing on year-end tax-loss harvesting, or selling securities at a loss to help offset taxes owed from capital gains in taxable investment accounts. Rebalance portfolios toward value-style, cyclical and international stocks.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Oct 25, 2021, “FOMO, TINA or Just Too Much Cash?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.