- Stock market valuations currently sit at multi-year highs.
- According to Morgan Stanley's Chief US Equity Strategist Mike Wilson, stocks have little room left to run, and they appear to be due for a period of underperformance.
- Wilson highlights three areas of the market where investors can find returns in Q1.
- Visit Business Insider's homepage for more stories.
US stocks are among the most expensive in the world at the moment.
But according to Morgan Stanley, valuations won't be getting much higher anytime soon.
Valuations are hitting a ceiling in the near term, and stocks are due for a period of underperformance, says Mike Wilson, Morgan Stanley's chief US equity strategist.
Wilson's latest technical analysis points to signs that stocks will see muted returns in the weeks ahead.
One feature is that the breadth of the market's recovery — the number of rising stocks compared to falling stocks — has become unsustainable. Right now, 92% of stocks are sitting above their 200-day moving averages, a level that Wilson points out is historically high — in the 98th percentile over the last 30 years.
"If history holds, we'd expect this metric to turn lower, which can happen via price corrections or moving averages rising as prices stall," Wilson said in a January 11 note.
He laid out in a chart, shown below, how stocks perform in the following five-day, one-month, and three-month periods when this indicator is as high as it is.
Wilson also said that rising 10-year Treasury yields — and therefore a lower equity risk premium — will continue to weigh on valuations as investors become increasingly willing to rotate their money into bonds.
But because the market's equity risk premium is already at relative lows because of stocks' strong outperformance since March, Wilson added that he sees little room to run for valuations no matter what happens with Treasurys.
"The bottom line is that P/Es have peaked on our framework even if 10-year yields remain excessively low in the foreseeable future," he wrote.
3 areas of the market to find returns
While Wilson had warned in December that some cyclical stocks had become overextended following November vaccine announcements, he said in the note on Monday that he expects the stocks to outperform in the first quarter as the economy recovers.
Closely aligned with his bullish outlook for cyclicals, he said he expects small-cap stocks outperform as well.
These calls stem in part from Democrats flipping the Senate following two runoff races in Georgia.
"The Blue Wave is just fuel for a more accelerated move," Wilson said. "In addition to this important political catalyst that supports our call for a regime shift from monetary to fiscal policy dominance, we also have earnings momentum, which is starting to favor smaller and more economically sensitive parts of the market."
Investors seeking exposure to cyclical and small-cap stocks might consider exchange-traded funds like Vanguard Consumer Discretionary ETF (VCR) and the Schwab US Small-Cap ETF (SCHA).
Wilson said this view extends even to areas within the technology sector, which accounts for some of the highest valuations in the market.
He said that because highly valued stocks face headwinds from rising interest rates, earnings revisions will be "even more important than usual for stock performance."
Within tech, Wilson said enterprise tech firms are the best positioned from this perspective.
"We have a neutral stance on the sector as a whole, preferring the more cyclically geared sectors like enterprise focused on tech hardware and [semiconductors]."
The VanEck Vectors Semiconductor ETF (SMH) offers exposure to semiconductor firms.
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