A new Federal Reserve forecast that the U.S. central bank will likely raise interest rates four times this year in response to high inflation and low unemployment prompted a prediction from a top Morgan Stanley analyst that a valuation reset will happen faster and sooner than expected.
Investors use the term “valuation reset” in relation to stocks that have seen massive growth in the past year and are now going down. “Really, it is just a fancy word for a mini-correction,” Jamie Adams wrote for MyWallSt Advisory.
The major averages tumbled sharply Tuesday as government bond yields hit covid-era highs and Goldman Sachs reported disappointing earnings.
The Nasdaq Composite fell by 2.4 percent to its lowest level in three months, the S&P 500 dropped 1.9 percent, and The Dow Jones Industrial Average declined by about 600 points or 1.7 percent.
The central bank recently signaled plans to raise interest rates three times in 2022. Investors have priced in an 81 percent chance of at least three interest rate hikes in 2022, according to the CMEGroup’s FedWatch tool. And there is a 53 percent chance of four or more rate hikes, compared with about 30 percent a month ago, CNN reported.
An interest rate “armageddon” would lead to a valuation reset across multiple asset classes including stocks, bonds and housing, wrote Ahan Vashi, author of “Beating the Market,” in Seeking Alpha.
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Known for being bearish, Morgan Stanley US equity strategist Michael Wilson said in his Jan. 18 Weekly Warm-Up, “Our new Fed forecast simply brings forward our call for lower equity valuations and raises the risk in the first half of the year. The median stock remains expensive even though the most egregiously priced stocks have corrected.”
The 10 most expensive stocks as of Dec. 27, 2021, included Amazon ($3,523 per share) and Google parent Alphabet – ($2,964 per share) according to Fortunly.
The new Fed forecast means the valuation reset will happen faster and sooner, Wilson said.
“With our economic team’s new Fed forecast for the end of QE, 4 rate hikes and the beginning of balance sheet normalization this year, our call for falling valuations is likely to happen faster and more broadly than our prior forecast. With earnings growth back-end loaded, this raises the risk for first half of the year. Valuation is broadly extended across the index…we find it very interesting that valuation under the surface of the index remains elevated from a historical standpoint.”
Wilson discussed valuations on CNBC‘s Dec. 14 “Halftime Report.”
“Valuations are just coming down and we made that call back in March and April of this year,” he said. “We called the midcycle transition, there’s going to be a rolling correction, and that’s kind of what’s happening … We had strong seasonal strength, we had incredible retail flows, we suggested that we could rally into Thanksgiving, maybe a little beyond that … we’re seeing the large-cap names are now starting to fall by the wayside, which is exactly what happened in 2018 the last time we had that rolling correction idea. And it always ends the same way. It ends with the bastions of safety finally taking a hit.”
Wilson had this advice for investors.
“First of all they shouldn’t be risk up,” he said. “The risk-reward has not been particularly great since September. … we are moving away from large-cap quality growth to large-cap quality defenses and that’s a big shift.”
Wilson predicted a slowdown in the first and second quarter of 2022 in which, he said, “we’re going to get gobs of inventory. The supply is going to catch up we’re probably seeing a peak rated change in the inflation rate. It’s still going to be high, it’s still going to be intolerable for the Fed, meaning 4 percent of inflation is not a level they’re comfortable with but they’re going to come down because the Playa‘s going to pick up and the question I think we have to ask, is that going to create an earnings problem for a lot of companies that people are not expecting earnings problems from?
“Look what’s happened,” Wilson continued. “Companies have expedited supplies, they’ve hired a bunch of labor at higher prices and if there’s excess supply now in the first or second quarter, potentially temporarily that could lead to margin compressions.”
In time for Halloween 2021, Morningstar Financial Services published a list of most scary, overpriced stocks on Oct. 26, 2021. Netflix topped the list. Here’s Morningstar’s full list for that day: Lululemon Athletica Inc (LULU), MSCI Inc (MSCI), Block Inc (SQ), Moderna Inc (MRNA), Sherwin-Williams Co (SHW), Netflix Inc (NFLX), Merck & Co Inc (MRK), Teleflex Inc (TFX), IDEXX Laboratories Inc (IDXX), Mettler-Toledo International Inc (MTD).
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