Look Out for the End of the Equity Rally

Jul 26, 2023

Despite favorable conditions for the U.S. economy and markets today, investors may still want to brace for a pullback.

Lisa Shalett

Key Takeaways

  • An ample supply of money in circulation has cushioned the U.S. economy and corporate profits from the impact of Fed rate hikes.
  • Also, many U.S. households and companies have locked in low interest rates, making them less sensitive to monetary tightening.
  • Still, recent data suggest the economy remains vulnerable and that investors may want to brace for another pullback in markets. 
  • Consider rebalancing investments toward value-style and “growth at a reasonable price” stocks as well as fixed income. 

The S&P 500 Index has advanced by 27% over the past nine months, with gains accelerating considerably in the past six weeks. This may seem extraordinary, and some investors’ enthusiasm around equities has led them to call the beginning of a bull market. But these recent gains aren’t all that different from prior bear-market rallies: In fact, in all seven bear markets since 1960, stocks have come close to reaching their prior highs before falling to their ultimate lows for the cycle, which is why we think investors may want to remain cautious today.


Sustaining the Gains – for Now

Should investors expect history to repeat itself, sending the current highs of the bear-market rally to new lows? Despite extensive tightening to monetary policy over the last year, two factors have kept the economy and markets buoyant and may do so for a while longer:


  • The sheer amount of money in circulation has helped to cushion the U.S. economy and corporate profits. The country’s “M2” money supply—which includes money in checking accounts, certificates of deposit and money market funds—sits at $20.8 trillion as of May. That’s down only slightly from a record high in July 2022, after pandemic-related government stimulus caused the supply to rise sharply in 2020 and continue to grow well into 2022, leaving still ample liquidity today.


  • Many U.S. individuals and companies have locked in low interest rates, which shores up their balance sheets. For many years prior to the recent Federal Reserve rate hikes, households and companies alike were able to borrow at historically low rates—think 2.65% for the average 30-year fixed-rate mortgage as of January 2021. This has made them less sensitive to the rapid rise in rates over the past year. 


Investors Should Still Be Cautious 

Together, these two factors have helped to keep the U.S. economy and corporate profits unusually resilient. But while stock market momentum is tempting, Morgan Stanley’s Global Investment Committee believes the current rally is driven by investors’ optimistic confidence in re-accelerating economic growth, the taming of inflation and falling interest rates in 2024. This bullish outlook ignores recent data signaling a more difficult road ahead: Industrial production is softening; The Conference Board’s composite index of leading economic indicators is deteriorating; existing home sales are weak; and bankruptcies are rising, as are the provisions that banks set aside for loans going sour.


In light of these concerning crosscurrents, we continue to emphasize caution. Investors should consider trimming the gains they’ve attained through passive exposure to U.S. stocks indices and rebalancing toward value-style and “growth at a reasonable price” stocks. Also look to fixed income, where increasingly solid real, or inflation-adjusted, yields are available.


This article is based on Lisa Shalett’s Global Investment Committee Weekly report from July 24, 2023, “Leads, Lags and Levels.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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