US stock valuations rich, Japan a better bet, says Morgan Stanley's Shalett

The S&P 500 was up over 10 percent in the first quarter of 2023, following a spike of more than 24 percent in 2024. That magnificent run was all thanks to moderating inflation, the (unstated) promise of Federal Reserve rate cuts and the hope that corporate earnings will catch up to a hot (but not overheated) economy.

Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, says that while the economy may have stuck the soft landing, the degree of difficulty in achieving the necessary earnings growth to maintain or expand current market valuations has risen to uncertain, and perhaps unattainable, levels.

“There is a lot of anticipation that we're going to get a material, double-digit, year-on-year rebound in earnings,” Shalett said. “We're a little skeptical about that even though growth is a little bit better. We're struggling with whether or not companies are truly going to be able to eke out material margin expansion, which is what the forecasts demand.” 

Earnings growth is not the only thing Wall Street's counting on. Coming into the year, the Street’s strategists were hanging their hats on up to 6 interest rate cuts from the Federal Reserve. After a string of hotter-than-expected inflation and jobs numbers in Q1, Wall Street’s consensus has sliced that prediction in half. And the figure could be reduced even further if the economy morphs from soft landing to no landing.

That could be a headwind for stocks, Shalett says. So too could rich valuations across the entire market-cap weighted index, not just the very pricey Magnificent 7 stocks, which ran away in 2023.

“We're selling at 21 times forward earnings, which are expected to grow double digits. So that's an ambitious forecast,” she said. “The Magnificent 7 were quite expensive, and they still sell at a premium to the rest of the market. But breadth has improved here in the first quarter and so now the median stock is selling for over 17 times forward earnings, and that I think is getting toward the upper bound of a fair valuation.”

So despite this being April, should investors "sell in May and go away"? 

“I'm not trying to time the market here, and I'm not predicting any kind of big sell-offs,” Shalett said. “But we've come a very long way, very fast. And I think it's prudent for investors to anticipate that there will be consolidation along the way.”

Investors worried about a potential downdraft might want to keep an eye on the VIX, which has remained under 15 over the past 6 months. Right now, the subdued volatility index doesn't unnerve Shalett. But it does remind her of how complacent investors have become, and how quickly things could change should financial conditions tighten.  

One area of the world where the tailwinds seem to outnumber the headwinds is Japan, according to Shalett. She's overweight Japan in her models and says stocks in the land of the rising sun could rise even higher.

“Happily, we caught that Japan trade as they were finally breaking out of that 34-year bear market and making new highs for the first time,” she said.