Why U.S. Stocks May Not Be Worth the Risk

The mood of equity investors has soured in the last month—but perhaps not as much as it should have.

In January, the S&P 500 Index rose 6% and the Nasdaq surged close to 11%, marking one of the strongest starts to a year in recent memory. Investors buoyed prices based on their belief that Federal Reserve tightening was bringing inflation back to its 2% target and that a pause in rate increases was on the horizon.

But investors were decidedly less cheery in February. As of Feb. 24, the S&P 500 and Nasdaq indices had retreated roughly 5% and 7%, respectively, from Feb. 2 peaks, amid signs that inflation is declining less quickly than anticipated. The labor market remains tight and consumer spending has stayed robust, helping maintain price pressures and incentivizing the Fed to keep policy tight.

Fixed-income traders have quickly accounted for this reality, pushing up Treasury yields and rate-hike expectations. However, even with benchmark U.S. equity indices in retreat in February, stock investors have seemed largely complacent, as though they still hold out hope that the recent economic data are little more than a blip on the path toward a soft landing.

Valuations Look Unattractive

As a result, U.S. stocks still look expensive and offer relatively low potential returns for the risk of owning them. Price-earnings ratios are above 18, versus around 15 in October. Importantly, the equity risk premium—or the extra return an investor can expect for investing in the stock market instead of risk-free 10-year Treasuries—is at its lowest level in about 20 years.

In fact, over the past two decades, this risk premium has sat between 300 and 350 basis points; currently it’s at 167. This isn’t much different from what an investor might expect to earn from investment-grade credit, which generally is considered less risky than stocks. What’s more, the S&P 500’s dividend yield is just 1.7%, compared with the 6-month Treasury bill, offering a yield greater than 5%.

Uncertainty Looms

Granted, in the mid-1990s and early 2000s, stocks were even more overvalued than today. And investors can perhaps afford to look past inflated valuations when economic fundamentals are hitting bottom, monetary policy is loosening and market expectations are low.

But we are not in such an environment. To the contrary, we are in a period of extreme uncertainty about the path ahead for the economy and markets. 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 pandemic in 2020.
• By the Fed’s own admission, there’s more work to be done to bring inflation down to its target, a path that is unlikely to be a straight line, as we have already begun to see in the latest economic data.
• The effects of monetary tightening tend to operate on a lag and have yet to really show up in the economy, with U.S. GDP trucking along at an above-average pace and unemployment at 53-year lows.

With economic and market uncertainty this high, U.S. stock investors would be wise to demand better risk compensation, such as a higher equity risk premium. Maintain solid exposure to yields and income, and despite the market buzz, resist a fear of missing out on U.S. equity market gains, because in truth, you aren’t missing much.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from February 27, 2023, “What’s Really Changed Is Valuation.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.