Will valuations see a floor? – Morgan Stanley’s Mike Wilson

If nominal GDP and earnings growth accelerate due to higher inflation, stocks’ valuation may see a support ahead, according to Michael J. Wilson, chief U.S. equity strategist and chief investment officer for Morgan Stanley.

Market multiples have expanded due to the beginning of a new economic cycle in April, expectations for future earnings growth recovery, and a higher inflationary regime that supports lower equity risk premiums, he said.

Also, the S&P 500 (SP500)/gold (XAUUSD:CUR) ratio – a reliable measure of real returns over time – currently stands almost 70% below its peak from 25 years ago, suggesting that stocks were significantly more expensive in 1999-2000 than they are today, Wilson said.

In addition, the primary risk for stocks (SP500), (COMP:IND), (DJI) in nominal terms may be that inflation decreases significantly, as this would indicate that earnings expectations are too optimistic, potentially making P/Es unsustainable, he said.

Current market multiples appear to be pricing in stronger growth than consensus forecasts suggest. The surge in AI capital expenditures that began in 2023 has initiated a new era for equity investors. Investors anticipate future payoffs from these investments, driving the market sentiment of “trust me – it’s not a question of if, but when the payoff will arrive,” Wilson said.

When comparing today’s market valuations to those of the late 1990s, the free cash flow yield for the median large cap stock (SP500) is significantly higher than it was in 1999, and the market multiple, when adjusted for profit margins, is trading at almost a 40% discount compared to that period. Today’s market is characterized by stronger free cash flow generation, operational efficiency, and robust profitability – all indicators of a higher quality index than what existed during the dot-com era, Wilson said.

Also, April 2024 appears to have marked the trough for the rolling recession that began in 2022, with a new economic cycle beginning at that time. This transition point typically coincides with significant P/E multiple expansion in anticipation of future earnings growth recovery, Wilson noted. The sharp V-shaped recovery in earnings revisions breadth strongly suggests that earnings expectations for next year will prove conservative, thereby justifying higher multiples.

Despite positive views on earnings and the cyclical impulse into 2026, the Federal Reserve is likely to continue cutting rates, primarily due to lagging labor data, Wilson added. The latest ADP report indicated continued weakness in the jobs market following the tariff-fueled sell-off earlier in the year. Moderately negative payroll data would likely be positive for equities, as it would keep the Fed cutting rates into next year.

The Healthcare sector (XLV) currently offers an attractive risk/reward opportunity, with accelerating earnings revisions across Pharma/Biotech (PJP), (XPH), (PPH), (XBI), (BBH) and Equipment/Services (XHE), coupled with historically cheap relative valuation, Wilson said. Biotech has historically been a strong outperformer during Fed rate cutting cycles and tends to benefit from lower back-end yields.

Also, recently, the sector experienced its strongest weekly performance since 2022 (up 7%) as the Trump administration’s MFN/drug pricing announcement with Pfizer triggered a relief rally.

The resolution of key clearing events (MFN and pharma tariffs) has attracted generalists back to Healthcare (XLV) after an extended period of muted sentiment. With relative valuation for the space remaining in the bottom 5th percentile of historical levels over the past 30 years, continued outperformance appears likely, Wilson concluded.