Are Markets Overpriced?

May 29, 2024

Stocks are rebounding on signs of economic cooling, but high valuations and an uncertain economic picture warrant caution.

Lisa Shalett

Key Takeaways

  • Investors have sent U.S. stocks to new all-time highs this month on hopes that a cooling economy will keep the Fed on track to cut rates.
  • However, valuations across asset classes look excessive, suggesting investors aren’t being duly compensated for the risks they’re taking.
  • In addition, economic uncertainty abounds, as lower-income consumers deplete their savings and a pivotal U.S. presidential election looms.
  • Investors should focus on risk management, favoring investments with quality cash flows and achievable earnings targets. 

Equity markets seem to be living up to the old saying, “April showers bring May flowers.” After declining about 5% in April, the S&P 500 Index has gained about 6% so far in May, hitting new all-time highs along the way.


Much of this renewed enthusiasm has been due to signs of economic cooling. Remember, investors had previously worried that the economy and inflation might be stronger than expected, potentially delaying the Federal Reserve’s interest rate cuts. Now, with growth appearing to slow, there’s been a sense of relief as investors expect that rate cuts are on the horizon. They are, once again, embracing the view that the economy will experience a “soft landing,” in which inflation abates without a recession, and as a result are complacently pushing valuations across asset classes to extremes. 

Valuations Are Stretched

A resurgent market might sound like a good thing at first blush. However, keep in mind that, with valuations increasingly stretched, investors are not being adequately compensated for the risks they’re taking. Consider these key metrics:

  1. 1
    The equity risk premium:

    This is the additional return an investor can expect for investing in stocks instead of “risk-free” U.S. government bonds. The S&P 500’s risk premium is currently at a mere 35 basis points, versus a long-term average of more than 250 basis points. The implied forward price/earnings (P/E) ratio is nearly 21, which is in the upper 90th percentile of the last 100 years of market history.

  2. 2
    The U.S. Treasury term premium:

    This is the extra compensation investors require for bearing the risk that interest rates may change over the life of a government bond; the longer the bond’s maturity, in theory, the higher this compensation should be. However, since peaking in October 2023 at roughly 40 basis points, the 10-year Treasury’s term premium has, once again, gone negative, despite the increasingly unsustainable government debts and deficits that make the future path of rates more uncertain.

  3. 3
    Option-adjusted spreads:

    This is a standard measure of the extra yield over Treasuries an investor expects when buying riskier types of bonds. For investment-grade credit currently, option-adjusted spreads are about 85 basis points, nearly 50 basis points below the long-term average.

Uncertainty Is High

At the same time, uncertainty has risen around economic growth, inflation and policy. While one could argue that U.S. growth in the second half of the year will reignite due to rebounding global activity, we believe potential disappointments abound.


Consider that lower-income U.S. consumers have depleted their excess savings, spent through credit-card limits and are now increasingly delinquent on debts. As such, they may be growing more dependent on a strong job market for continued spending. In addition, regional banks are seeing weak demand from small and medium-sized businesses, whose confidence has recently plummeted, and problems are looming in commercial real estate.


The U.S. presidential election outcome is another area of uncertainty with significant economic implications. A continuation of “Bidenomics” would likely support growth-enhancing fiscal investments, increasing taxes and extending deficit spending, while liberal immigration policies could be disinflationary by growing the labor force. Republican proposals, meanwhile, could make 2017 tax cuts permanent and bring inflationary policies around closed borders and higher tariffs.


Taken individually, investor complacency, economic uncertainty and high valuations might not be cause for concern, but together, they are a dangerous combination that suggests almost no room for disappointment.

How to Invest

Valuation is one of the single most important inputs to long-term returns. With valuations as rich as they are right now, Morgan Stanley’s Global Investment Committee recommends a thoughtful risk-adjusted approach to new investments at current prices, and encourages realistic expectations of returns.


Investors should consider balancing positive or negative skews in their portfolios with active stock-picking, focusing on quality cash flows and achievable earnings targets.


Investors may also want to consider options, which confer the right (but not an obligation) to buy or sell an underlying asset, such as a company’s stock, at a stated price by a certain date. Options on the CBOE Volatility Index may benefit investors depending on if equity volatility rises or falls, while put options on the S&P 500 may help hedge a portfolio from sharp drops in the stock index.


International stocks and real assets—such as gold, real estate investment trusts (REITs), master-limited partnerships (MLPs) and commodities—may be useful as potential portfolio diversifiers.


This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 28, 2024, “Valuations Don’t Matter Until They Do.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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