What’s the best metaphor to describe the stock market, which has pushed the S&P 500 up 16% from its lows in October and 6% this year?
Morgan Stanley strategist Mike Wilson turned to Jon Krakauer’s bestseller “Into Thin Air,” which chronicles the deaths of 12 climbers trying to scale Mount Everest. The book dives into the Death Zone, which begins 3,000 feet from the mountaintop, an altitude where there is not enough oxygen pressure to sustain life for an extended period of time.
“Either by choice or necessity, investors have once again followed stock prices to dizzying heights as liquidity (bottled oxygen) allows them to climb into a region where they know they cannot. shouldn’t go and can’t live very long,” Wilson said. “They climb in pursuit of the ultimate peak out of greed, assuming they can descend without catastrophic consequences. But the oxygen eventually runs out and those who ignore the risks are hurt.
Wilson says that when stocks started rising in October, they were at a much lower valuation, with a price-to-equity ratio of 15 and an equity risk premium of 270 basis points. The equity risk premium is the difference between the expected earnings return and the safe Treasury yield, with a higher number meaning investors are better compensated for their equity investments.
In December, however, “the air started to clear” with P-to-Es at 18 and an equity risk premium at 225 basis points. “Over the last few weeks of the year we have lost many climbers who have pushed further into the death zone,” he said.
But then 2023 began, and “the surviving climbers decided to make another attempt at the summit, this time taking an even more dangerous route with the most speculative stocks in mind”, on the mistaken premise of a break from the Fed’s rate hike, to be followed by cuts later in the year.
“Investors began to act faster and more aggressively, speaking with more confidence of a soft landing for the US economy. As they have reached even higher levels, there is now talk of a ‘no landing’ scenario – whatever that means. These are the tricks the Death Zone plays on the mind – you start seeing and believing in things that aren’t there,” Wilson says.
The “no landing” scenario is one of the most closely associated with Torsten Slok, the chief economist at Apollo Global Management. It should be noted that Slok argues that a no-landing scenario – where the economy does not slow down – is not good for markets, as it will require more aggressive Fed rate hike activity.
Back to Wilson, who says the P/E ratio is now 18.6 and the equity risk premium is 155 basis points, which means “we’re in the thinnest airs in the whole market.” liquidity-driven secular bull that started in 2009”. He says the bear market rally that started in October from reasonable prices has turned into a speculative frenzy based on a Fed pause/pivot that isn’t coming.
Certainly, he says, liquidity, mainly boosted by the Chinese and Japanese central banks, has helped push global M2 – a measure of money supply – up $6 trillion since October, “providing the extra oxygen which investors need to survive in the “death zone” a little longer.
The US stock market is closed Monday on Washington’s birthday. Last week, the Dow Jones Industrial Average
and S&P 500
fell, while the Nasdaq Composite
increased for the sixth time in seven weeks.