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The S&P 500 is already trading above the 3900 year-end price target of economists at Morgan Stanley. However, they are not raising that target. Instead, the economists are doubling down on why they think the upside for the main US index is capped for the rest of the year.  

Valuations are too high and will adjust materially lower over the next six months

“The primary reason we think valuation will prove to be a headwind is we’ve left the early cycle part of this recovery. We call it the mid-cycle transition, and it tends to coincide with the peak rate of change in policy and growth. Typically, during this period, the price earnings multiple for the S&P 500 falls by approximately 20%. So far, it’s declined by just 5%.”

“Long-term interest rates have moved significantly higher this year, as many of the most expensive and speculative parts of the equity market have de-rated significantly, some by as much as 50%. That tells us the de-rating is well underway and will eventually drive the multiple for the S&P 500 down by another 10-15%.”

“Earnings expectations have finally caught up to the reality of this V-shaped recovery. More specifically, estimates now reflect the strong operating leverage we predicted would happen last year. Some of this is due to the speed and strength of the recovery itself and the quick return of demand and sales. The recovery in profitability is a function of the unprecedented policy support that amounted to a giant corporate subsidy in labor costs. But now the reopening of the economy is likely to put upward pressure on costs and downward pressure on margins. This will come as a surprise to now lofty earnings estimates.”

“Higher corporate taxes are likely coming this fall. While it’s unlikely the administration will get the full hike to 28% it’s seeking, we do think a compromise is likely to be passed. Our best guess is that these changes will negatively affect S&P 500 earnings estimates for next year by approximately 5%. When combined with the margin pressure we see from continued supply chain issues and labor availability, it’s unlikely earnings can offset the valuation reduction we still think is to come.”

 

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