With markets displaying a number of similarities to the late 1990s, can investors expect the same kind of blow-off rally to close out the eight-year-old cyclical bull market?
Have markets come too far too fast? Or should investors stay at the party a while longer?
Investor angst about markets having run too far too fast is predicated on many concerns, the most common of which is valuation. With the strong rally in stocks and sell-off in bonds, many investors and strategists are now asking if markets have become overvalued. The consensus view is that stocks have become expensive and therefore the next correction could be quite meaningful—possibly 10% or 20%.
Our view at the Global Investment Committee—Morgan Stanley’s group of seasoned investment professionals who meet regularly to discuss the global economy and markets—is that U.S. stocks remain fairly priced at worst and downright cheap in the context of such low interest rates. Outside the U.S., stocks are even cheaper given investors’ less optimistic view about growth and/or political concerns in many of these regions.
Not All Metrics Are Created Equal
One of the problems with valuation metrics is that there are so many of them and everyone has their favorite. Our metric at the Global Investment Committee is simply the consensus bottom-up 12-month forward earnings estimate divided by the average corporate borrowing rate, for which we use Moody’s Baa yield. Right now that sets our “fair value” measure for the S&P 500 today at 2,833.
We focus on the fair value measure described above because it incorporates both earnings and interest rates while many traditional measures ignore interest rates altogether. We think such an omission is fundamentally flawed as lower interest rates can and should have a dramatic effect on valuations.
More importantly, we think the relationship shown in the chart above illustrates that such a measure has done a good job of keeping investors informed about valuation over time. First, it clearly identified the overvaluation in the 1990s for which investors ultimately paid dearly in 2001 and 2002. Second, it did a very good job of explaining why stocks collapsed so badly in 2008 and 2009— earnings forecasts collapsed and corporate borrowing rates rose significantly.
Finally, the chart does a great job of illustrating just how much the financial crisis scarred investors’ psyches and strongly suggests we have yet to reach an excessive level of optimism, or euphoria, during this cyclical bull market. In other words, euphoria is yet to come and we think that period is just beginning.
Predicting "Irrational Exuberance"
Another very good and popular valuation metric is the cyclically adjusted price earnings ratio (CAPE). It’s also known as the “Shiller P/E” after its creator, Nobel laureate and Yale University economist Robert Shiller. Understanding that earnings are highly cyclical due to economic expansions and recessions, the Shiller P/E essentially normalizes earnings by taking the 10-year average historical earnings for the denominator rather than using a single point estimate.
What Shiller discovered is that this measure does not tell us much about the near-term valuation of the broader stock market but in the long term it is exceptionally accurate as you can see below.
In short, the current Shiller P/E has been an uncanny predictor of the 10-year forward compounded annual returns of the stock market. This adds credence to the claim that in the end, valuations are your best margin of safety when investing. Buy a good asset at a good price and you will make a solid return over the long run. Of course the corollary holds as well—don’t overpay or you will be sorry.
Never was this mantra more true than the late 1990s. Obviously, the Shiller P/E was abnormally high in that period and though investors did well in the short term while ignoring these warnings, they ultimately paid the price when the tech bubble burst in 2001 and 2002.
With the Shiller P/E approaching higher levels, many investors have worried about getting fooled again. However, we are still well below the levels reached in the late 1990s and at current levels the Shiller P/E is telling us to expect lower, but not negative returns in the next 10 years. With interest rates so low, that means stocks still look relatively attractive.
While the Shiller P/E has not proven to be a good market timer, we found that we could accurately project near-term prices by using the Shiller P/E from 10 years ago (see below).
The Shiller P/E would have correctly kept you fully invested in U.S. stocks during this entire cyclical bull market. And, it’s still telling us to remain fully invested despite its above-average reading. That’s because next year’s price is based on what the metric was saying back in 2007 and 2008, not what it is saying today.
Specifically, the Shiller methodology is projecting a fairly steep acceleration in the S&P 500 during the next 18 months. It gives us an upside target of 2,778 on the S&P, coincidentally the same target suggested by our fair value model. In other words, both our S&P 500 fair value method and the Shiller P/E support significantly higher equity prices.
Note: This article first appeared in the January 2016 edition of “Positioning,” a publication of the Global Investment Committee, which is available on request.
International investing entails greater risk, as well as
greater potential rewards compared to U.S. investing. These risks include
political and economic uncertainties of foreign countries as well as the risk
of currency fluctuations. These risks are magnified in countries with emerging
markets, since these countries may have relatively unstable governments and
less established markets and economies.
Bonds are subject to interest rate
risk. When interest rates rise, bond prices fall; generally the longer a bond's
maturity, the more sensitive it is to this risk. Bonds may also be subject to
call risk, which is the risk that the issuer will redeem the debt at its
option, fully or partially, before the scheduled maturity date. The market
value of debt instruments may fluctuate, and proceeds from sales prior to
maturity may be more or less than the amount originally invested or the
maturity value due to changes in market conditions or changes in the credit
quality of the issuer. Bonds are subject to the credit risk of the issuer. This
is the risk that the issuer might be unable to make interest and/or principal
payments on a timely basis. Bonds are also subject to reinvestment risk, which
is the risk that principal and/or interest payments from a given investment may
be reinvested at a lower interest rate.
Bonds rated below investment grade may have speculative
characteristics and present significant risks beyond those of other securities,
including greater credit risk and price volatility in the secondary market.
Investors should be careful to consider these risks alongside their individual
circumstances, objectives and risk tolerance before investing in high-yield
bonds. High yield bonds should comprise only a limited portion of a balanced
Investing in commodities entails significant risks.
Commodity prices may be affected by a variety of factors at any time, including
but not limited to, (i) changes in supply and demand relationships, (ii)
governmental programs and policies, (iii) national and international political
and economic events, war and terrorist events, (iv) changes in interest and
exchange rates, (v) trading activities in commodities and related contracts,
(vi) pestilence, technological change and weather, and (vii) the price
volatility of a commodity. In addition, the commodities markets are subject to
temporary distortions or other disruptions due to various factors, including
lack of liquidity, participation of speculators and government intervention.
Equity securities may fluctuate in response to
news on companies, industries, market conditions and general economic
Investing in smaller companies involves greater risks not
associated with investing in more established companies, such as business risk,
significant stock price fluctuations and illiquidity.
Stocks of medium-sized companies entail special risks, such as
limited product lines, markets, and financial resources, and greater market
volatility than securities of larger, more-established companies.
Value investing does not guarantee a profit or eliminate
risk. Not all companies whose stocks are considered to be value stocks are able
to turn their business around or successfully employ corrective strategies
which would result in stock prices that do not rise as initially expected.
Growth investing does not guarantee a profit or
eliminate risk. The stocks of these companies can have relatively high
valuations. Because of these high valuations, an investment in a growth stock
can be more risky than an investment in a company with more modest growth expectations.
Companies paying dividends can reduce or cut payouts at any
Investing in foreign emerging
greater risks than those normally associated with domestic markets, such as
political, currency, economic and market risks.
Investing in currency involves additional special
risks such as credit, interest rate fluctuations, derivative investment risk,
and domestic and foreign inflation rates, which can be volatile and may be less
liquid than other securities and more sensitive to the effect of varied
economic conditions. In addition, international investing entails greater risk,
as well as greater potential rewards compared to U.S. investing. These risks
include political and economic uncertainties of foreign countries as well as
the risk of currency fluctuations. These risks are magnified in countries with
emerging markets, since these countries may have relatively unstable
governments and less established markets and economies.
Asset allocation and
do not assure a profit or protect against loss in declining financial markets.
The indices are unmanaged. An investor cannot
invest directly in an index. They are shown for illustrative purposes only and
do not represent the performance of any specific investment.
The indices selected by Morgan Stanley
to measure performance are representative of broad asset classes. Morgan
Stanley Smith Barney LLC retains the right to change representative indices at
Morgan Stanley Wealth Management
is the trade name of Morgan Stanley Smith Barney LLC, a registered
broker-dealer in the United States. This material has been prepared for
informational purposes only and is not an offer to buy or sell or a
solicitation of any offer to buy or sell any security or other financial
instrument or to participate in any trading strategy. Past performance is not
necessarily a guide to future performance.
The author(s) (if any authors are
noted) principally responsible for the preparation of this material receive
compensation based upon various factors, including quality and accuracy of
their work, firm revenues (including trading and capital markets revenues),
client feedback and competitive factors. Morgan Stanley Wealth Management is
involved in many businesses that may relate to companies, securities or
instruments mentioned in this material.
This material has been prepared
for informational purposes only and is not an offer to buy or sell or a
solicitation of any offer to buy or sell any security/instrument, or to participate
in any trading strategy. Any such offer would be made only after a prospective
investor had completed its own independent investigation of the securities,
instruments or transactions, and received all information it required to make
its own investment decision, including, where applicable, a review of any
offering circular or memorandum describing such security or instrument. That
information would contain material information not contained herein and to
which prospective participants are referred. This material is based on public
information as of the specified date, and may be stale thereafter. We have no
obligation to tell you when information herein may change. We make no
representation or warranty with respect to the accuracy or completeness of this
material. Morgan Stanley Wealth Management has no obligation to provide updated
information on the securities/instruments mentioned herein.
discussed in this material may not be suitable for all investors. The
appropriateness of a particular investment or strategy will depend on an
investor's individual circumstances and objectives. Morgan Stanley Wealth
Management recommends that investors independently evaluate specific
investments and strategies. The value of and income from investments may vary
because of changes in interest rates, foreign exchange rates, default rates,
prepayment rates, securities/instruments prices, market indexes, operational or
financial conditions of companies and other issuers or other factors. Certain
information contained herein may constitute forward-looking statements.
Estimates of future performance are based on assumptions that may not be
realized. Actual events may differ from those assumed and changes to any
assumptions may have a material impact on any projections or estimates. Other
events not taken into account may occur and may significantly affect the
projections or estimates. Certain assumptions may have been made for modeling
purposes only to simplify the presentation and/or calculation of any
projections or estimates, and Morgan Stanley Wealth Management does not
represent that any such assumptions will reflect actual future events.
Accordingly, there can be no assurance that estimated returns or projections
will be realized or that actual returns or performance results will not
materially differ from those estimated herein.
This material should not be
viewed as advice or recommendations with respect to asset allocation or any
particular investment. This information is not intended to, and should not,
form a primary basis for any investment decisions that you may make. Morgan
Stanley Wealth Management is not acting as a fiduciary under either the
Employee Retirement Income Security Act of 1974, as amended or under section
4975 of the Internal Revenue Code of 1986 as amended in providing this
Morgan Stanley Smith Barney LLC,
its affiliates and Morgan Stanley Financial Advisors do not provide legal or
tax advice. Each client should always consult his/her personal tax and/or legal
advisor for information concerning his/her individual situation and to learn
about any potential tax or other implications that may result from acting on a
This material is disseminated in
Australia to "retail clients" within the meaning of the Australian
Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N.
19 009 145 555, holder of Australian financial services license No. 240813).
Morgan Stanley Wealth Management
is not incorporated under the People's Republic of China ("PRC") law
and the research in relation to this report is conducted outside the PRC. This
report will be distributed only upon request of a specific recipient. This
report does not constitute an offer to sell or the solicitation of an offer to
buy any securities in the PRC. PRC investors must have the relevant
qualifications to invest in such securities and must be responsible for
obtaining all relevant approvals, licenses, verifications and or registrations
from PRC's relevant governmental authorities.
If your financial adviser is
based in Australia, Switzerland or the United Kingdom, then please be aware
that this report is being distributed by the Morgan Stanley entity where your
financial adviser is located, as follows: Australia: Morgan Stanley Wealth
Management Australia Pty Ltd (ABN 19 009 145 555, AFSL No. 240813);
Switzerland: Morgan Stanley (Switzerland) AG regulated by the Swiss Financial
Market Supervisory Authority; or United Kingdom: Morgan Stanley Private Wealth
Management Ltd, authorized and regulated by the Financial Conduct Authority,
approves for the purposes of section 21 of the Financial Services and Markets
Act 2000 this material for distribution in the United Kingdom.
Morgan Stanley Wealth Management
is not acting as a municipal advisor to any municipal entity or obligated
person within the meaning of Section 15B of the Securities Exchange Act (the
"Municipal Advisor Rule") and the opinions or views contained herein
are not intended to be, and do not constitute, advice within the meaning of the
Municipal Advisor Rule.
This material is disseminated in
the United States of America by Morgan Stanley Smith Barney LLC.
Third-party data providers make
no warranties or representations of any kind relating to the accuracy, completeness,
or timeliness of the data they provide and shall not have liability for any
damages of any kind relating to such data.
This material, or any portion
thereof, may not be reprinted, sold or redistributed without the written
consent of Morgan Stanley Smith Barney LLC.
© 2017 Morgan Stanley Smith
Barney LLC. Member SIPC. All rights reserved.
CRC 1690198 (1/17)