Why are stocks so expensive right now? One Wall Street strategist has a theory.

By Joseph Adinolfi

Morgan Stanley's Mike Wilson chalks it up to booming liquidity and heavy deficit spending

Interest rates in the U.S. are at their highest levels in decades, so why are U.S. stocks so darn expensive? It's a question that has puzzled many on Wall Street.

But Morgan Stanley's Mike Wilson has a theory, which he articulated in a research report shared with MarketWatch on Monday.

In the report, Wilson, chief U.S. equity strategist at Morgan Stanley, chalked up stocks' strong performance over the past year to a combination of improving liquidity, driven largely by the ongoing drain of assets out of the Fed's reverse-repo facility, and unusually heavy deficit spending, which has helped boost economic growth without substantially boosting corporate earnings.

These factors, combined with easing financial conditions and a market that had become oversold back in October, have helped to slingshot stocks higher.

The tension between strong GDP growth and tepid earnings growth has created a sense of ambiguity that has helped to lift stocks, as investors bet that corporate earnings will eventually benefit from a stronger economy.

As Wilson pointed out, 90% of the S&P 500's advance since its October 2022 low has been driven by multiple expansions, meaning investors are paying increasingly high prices for every unit of expected earnings growth over the coming year. The S&P 500 is now trading at more than 20 times forward earnings, well above its 20-year historical average of 15.6, according to FactSet.

Whether or not stocks finally make good - or whether that improvement affects more than a handful of megacap stocks - remains to be seen.

But the more immediate concern is that lofty valuations could leave the market in a vulnerable position as the tide of liquidity begins to ebb, with the Fed's reverse repo facility nearly drained. The end of a central bank emergency-lending facility launched in the aftermath of Silicon Valley Bank's collapse one year ago could pressure the tide of liquidity further.

In an effort to explain the disconnect between GDP and earnings, Wilson noted that deficits of 6% to 7% of GDP are unusual outside of a recession. He surmised that government spending has helped to "crowd out" the private sector.

Evidence of this dynamic can be found in the widening gap between gross domestic income and gross domestic product, with the latter outpacing the former by the widest margin in years. These two barometers of economic strength typically move in the same direction, but it has been a while since that has been the case.

Furthermore, improving earnings growth at the index level might not be enough to justify the market's current price. For the market to continue chugging higher, investors will likely need to see earnings growth beyond a handful of megacap companies.

Read more: Alphabet is the bargain stock among the 'Magnificent Seven'

Recently, a group of seven stocks known as the Magnificent Seven has driven practically all of the earnings growth for the S&P 500. Data from FactSet shows that earnings growth for S&P 500 companies would have been negative in the fourth quarter if it wasn't for these seven companies: Nvidia Corp. (NVDA), Apple Inc. (AAPL), Microsoft Corp. (MSFT), Tesla Inc. (TSLA), Amazon.com Inc. (AMZN) Alphabet Inc. (GOOGL) and Meta Platforms Inc. (META)

Excluding the Magnificent Seven, the aggregate S&P 500 earnings would have contracted during the fourth quarter by 1.9%. Instead, the index saw growth of 7.6% year-over-year.

U.S. stocks appeared to be feeling the pressure over the past week as the main indexes notched their third weekly loss in the past four and a half months.

Stocks were mostly lower once again on Monday, with the S&P 500 SPX down 0.1% at 5,120, and the Nasdaq Composite COMP off 0.1% at 16,062. Meanwhile, the Dow Jones Industrial Average DJIA was marginally higher, up 27 points, or 0.1%, at 38,751.

-Joseph Adinolfi

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03-11-24 1402ET

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