Morgan Stanley Says Stocks Have Entered The “Death Zone”

Morgan Stanley Says Stocks Have Entered The “Death Zone”
Stéphane Renevier, CFA

about 1 year ago1 min

Mentioned in story

One of the biggest risks for alpinists is the “death zone” – the altitude at which oxygen becomes so low that even the most minor mistakes can be fatal. Morgan Stanley says that’s precisely the zone where US stocks find themselves now.

If valuations are a bit like the mountain’s altitude, the equity risk premium (ERP) – i.e the extra return that stocks are expected to deliver over bonds – is a bit like oxygen: the higher it is, the more “margin of safety” alpinists (i.e. investors) have in case something goes wrong.

In October, both provided somewhat safe conditions for alpinists: the price-to-earnings ratio (P/E) was a not-so-extreme 15x while the ERP was close to 3%. That encouraged many alpinists to set their sights on the summit. But after reaching a P/E altitude of 18x in December, and with that ERP “oxygen” dropping to a low of 2% – levels consistent with the death zone – many alpinists went back to the safety of base camp.

But some investors couldn’t give up on their dreams of higher highs. From the start of this year, these daredevils climbed an even riskier path, loading up on speculative stocks and leading the group back to higher highs. That’s where we are now: with P/Es at a high 18.6x and the ERP at its lowest level since 2007, stocks have never been so far into the death zone and for so long.

This doesn’t mean investors won’t be able to reach the summit and come back alive, but with altitude this high and oxygen levels this low, there’s very little room for error. So feel free to make the climb, but don’t underestimate the risks, and make sure you’ve got a plan to make it back safely.

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