Why US stocks may not be worth the risk

In an environment of elevated valuations and interest rates, the risks of owning US equities may outweigh the benefits today, according to the latest Morgan Stanley report. Over the past month, the major US stock indices have given up a significant chunk of their January gains.

Still, valuations remain high and the stock risk premium is at 20-year highs. Equity investor sentiment has deteriorated over the last month, but probably not as much as it could due to the increase in the risk-free rate.

In January S&P 500 index increased by 6%, and Nasdaq by nearly 11%, which was one of the best beginnings of the year in recent times. Investors raised share prices, believing that policy tightening by Federal Reserve inflation to 2% and that a halt to interest rate hikes is on the horizon. However, investors were much less happy in February due to signs that inflation was falling more slowly than expected.

The labor market remains “tight” and consumer spending remains high, which helps to maintain price pressures and encourages the Fed to maintain tight monetary policy. Derivatives investors quickly embraced this reality, raising government bond yields and expectations of a rate hike. But even with major US equity indices retreating in February, stock investors seem largely complacent, as if they still hope the latest economic data is just a small glimmer on the road to a soft landing.

Valuations look unattractive

As a result, US stocks still look expensive and offer relatively low potential returns relative to the risk of holding them, according to MS. Price-earnings ratios are above 18, down from around 15 in October. Importantly, the equity risk premium - the extra return an investor can expect to invest in the stock market instead of risk-free 10-year Treasuries - is at its all-time low for about 20 years. In fact, over the past two decades, the risk premium has been in the range of 300-350 basis points, and is now 167.

This is not much different from what an investor might expect from an investment grade loan, which is generally considered less risky than stocks. What's more, the S&P 500's dividend yield is just 1,7%, while the 6-month Treasury yield is over 5%.

Uncertainty

Admittedly, in the mid-90s and early XNUMXs, stocks were even more overvalued than they are today. Investors can perhaps afford to ignore overvaluations when economic fundamentals hit rock bottom, monetary policy loosens and market expectations are low. However, we are not in such an environment today, argues Morgan Stanley. On the contrary, we are in a period of extreme uncertainty about the future path of the economy and markets.

Let's consider that:

• Trends in leading economic indicators are at negative levels not seen since 2008 and 2009, except for a brief period in the early days of the 2020 pandemic.
• As the Fed itself acknowledges, there is more work to be done to bring inflation to its target, and the path is unlikely to be a straight line, as we have already begun to see in the latest economic data.
• The effects of monetary policy tightening are delayed and have not yet manifested themselves in the economy, with the US GDP remaining at an above-average level and unemployment at a 53-year low.
• With so much economic and market uncertainty, investors investing in US equities should demand better risk compensation, such as a higher equity risk premium. Otherwise, investors shouldn't be afraid of losing US stock market gains through lack of exposure, because they won't really lose much.