The valuations are just too high to chase, says Morgan Stanley analyst

The exceptional shares rebound so far is just another bear market rally and not the start of a bull run, says Morgan Stanley’s Lisa Shalett.

Lisa Shalett tells investors to focus on defensive sources of income.

An “eye-popping rebound” in shares this year is just another bear market rally and not the start of a new bull market, Morgan Stanley Asset Management chief investment officer Lisa Shalett says.

While the magnitude of the rebound in shares this year has taken many by surprise, Shalett argues that it’s been a “liquidity-driven speculative rebound” and valuations are “too high to chase”.

After falling as much as 14 per cent last year, Australia’s S&P/ASX 200 index has bounced as much as 18 per cent from its mid-2022 low. As of Thursday, it was less than 2 per cent away from a record high.

US shares suffered deeper falls amid aggressive US interest rate increases last year. But by early this month, the S&P 500 had bounced almost 17 per cent from its October bear market low.

The Nasdaq Composite bounced 20 per cent from late December to early February.

The Australian market had good reasons to rebound: China’s earlier than expected reopening supported the economic outlook, iron ore prices have shot up in recent months and, at least until this week’s hawkish Reserve Bank statement, the central bank was thought to be near the end of its rate rises.

But while cooling inflation led the Fed to further reduce the size of its rate increases this month, the US market pushed on, even as the bond market warned of a recession, and Fed officials indicated that they had a higher than normal inflation bar to jump before any “pivot” to rate cuts.

So what happened to that ferocious bear market?

In some regards, Shalett can acknowledge the drivers of the sharemarket’s enthusiasm.

Despite plenty of cash on the sidelines and aggressively easing financial conditions, year-end 2022 sentiment and positioning were bearish. Inflation news was improving, while consumers were still spending and labour markets were staying strong, fuelling hope of a “soft landing”.

The worst of China’s Covid-linked recession seemed to be ending, and the Federal Reserve was widely forecast to downshift the pace of rate increases to 25 basis points per meeting.

But the January rally was driven by a “massive short-covering rally with a classic pattern of ­annual reversal” – where traders buy the laggards that were sold in December for “tax-loss” pur­poses.

Indeed, 2022’s biggest losers outperformed the surging market by two to three times.

Bulls will justify the strength as the precursor of a “Goldilocks scenario”, where the Fed pulls off an elusive soft landing after taming runaway inflation, while only modestly inhibiting employment, growth and corporate profits.

But the fundamental economic facts weren’t confirmatory, according to Shalett.

Leading economic indicators for retail sales, manufacturing data and CEO confidence were weakening, and fourth quarter earnings were decelerating sharply.

December quarter US earnings “beats” were running at a lower-than-usual 69 per cent, even after expectations were slashed in the weeks before reporting kicked off last month.

Recession indicators were “flashing caution” and bond yield curves remained deeply inverted.

The US market’s cyclicals/defensives ratio, relative to leading economic indicators, has never been as divergent as it is now. Something didn’t add up.

It seems investors have been “reading past the facts” for a bullish narrative, dependent on an unlikely combination of no US recession, but also interest rate cuts in the second half. The US sharemarket has never started a bull market even before a recession even started.

But with the CBOE VIX volatility index hitting a 52-week low, positive technical signals including a “golden cross” forming on the S&P 500, and Fed chairman Jerome Powell remaining calm after surprisingly strong US jobs data, shares have remained well-supported at the start of February.

Meanwhile, the two-year US Treasury yield has fallen below the Fed funds rate, a sign of overtightening that ends in a hard landing, and the two to 10-year spread has remained deeply inverted.

Rates-obsessed equity investors are expanding valuation multiples with no consideration for what those rates truly signal: lower growth and lower pricing power.

“The implication is that the S&P 500 price/earnings multiple, at 19 times forward earnings, has expanded on falling earnings,” Shalett says.

Another sign that the sharemarket is off course has been the recent outperformance of gold.

Gold has probably been helped by rising risks related to the debt ceiling and sharp increase in one-year Treasury credit default swaps, but if growth were in fact stabilising or rebounding (as implied by stocks), gold would not be holding its bid.

Shalett tells investors to focus on defensive sources of income – including short to intermediate-term US Treasuries, municipals, investment grade corporate bonds and dividend-growth stocks with above average yields and reliable earnings.