No, Stocks Aren’t Pricing In A ‘V-Shaped’ Recovery, Morgan Stanley Says

“Markets are pricing in a ‘V-shaped’ recovery”, goes one common refrain.

“Just look at stocks!”, folks will exclaim.

It’s true that a cursory glance at the S&P and, say, high yield spreads, versus levels (not changes) on key economic indicators suggests risk assets are optimistic, and perhaps unduly so.

“The domestic labor market has only managed to replace a third of the pandemic job losses”, BMO reminds you.

But one point I’ve pretty keen to emphasize in these pages over the course of the last several weeks, is that although equities expressions indicative of a pro-cyclical rotation did, in fact, outperform for a spell, their moment in the sun was fleeting.

The figure (above) is just one way to visualize the situation. A high beta product in ETF land is down four of the last five weeks after surging in late May, popular growth ETFs have generally outperformed their value counterparts in five consecutive weeks, and the retail momentum factor vehicle (MTUM) has bested a value factor ETF each week since early June.

The point: The way in which stocks are rallying is not indicative of growth optimism. The Nasdaq trading at record highs (with poor breadth on some metrics) is the quintessential example of investors pivoting to secular growth favorites as the outlook for a robust recovery is dampened by renewed lockdowns in some states where virus cases are rising.

Morgan Stanley’s Andrew Sheets talks a bit about this in a new note. This is the key passage:

But if investors expect a robust economic bounce back, they have an odd way of expressing it. Long-term US and European yields are very low. Inflation expectations are very low. Yield curves are very flat. Implied volatility is high. And smaller, cyclical, lower quality companies trade at a historically large discount. Needless to say, all those represent wagers against a strong recovery, and instead, on a world where growth remains weak and uncertainty remains high.

To drive the point home, Sheets goes on to note that market participants who cite optically absurd valuations (versus the state of the global economy) invariably express a preference for the most stretched corners of the market.

“One of the best examples of this paradox is in growth versus value”, he writes, adding that “global equities, trading at 20x forward earnings, is often cited as clear evidence that valuations have run ahead of the economic reality [but] when you ask investors what part of the market they prefer, it’s the most extremely valued subset — growth stocks”.

Of course, the situation has improved a bit since the panic lows in terms of what the market is pricing for growth. For example, breakevens have risen, the curve has steepened, the dollar is lower, and oil is higher.

But the overarching point from Sheets is that “valuations are still a long way from implying a normal recovery, and instead reflect a market that remains concerned about long-term growth”.

You might argue those concerns are entirely justified. But the message for those willing to take even a cursory glance under the hood of the equity market is that stocks are not pricing in a “V-shaped” recovery. In fact, given ongoing leadership in names that should perform in a slow-flation world characterized by reduced in-person interactions, you might argue exactly the opposite.