Where is the bottom of the valuation? Morgan Stanley warns: A sharp drop in inflation is the biggest threat to the US stock market

According to the Zhitong Finance APP, Michael Wilson, Chief U.S. Equity Strategist and Chief Investment Officer at Morgan Stanley, pointed out that if nominal GDP and earnings growth accelerate due to rising inflation, stock valuations may receive support. He analyzed that since the new economic cycle began in April, the expansion of market price-to-earnings ratios has benefited from three main factors: the start of a new cycle, expectations for future earnings recovery, and the support of a high inflation environment for stock risk premiums. Wilson particularly emphasized that the ratio of the S&P 500 index to gold—a reliable indicator of long-term real returns—is currently nearly 70% lower than its peak 25 years ago, intuitively reflecting that stock prices in 1999-2000 were much higher than current levels.

Regarding potential risks, Wilson warned that from a nominal perspective, the main threat to stocks may be a significant decline in inflation. If inflation drops significantly, it may indicate that current earnings expectations are overly optimistic, leading to difficulties in maintaining price-to-earnings ratios. He further pointed out that the current market price-to-earnings ratio implies stronger growth momentum than generally expected. Since 2023, the surge in capital expenditures in the artificial intelligence sector has opened a new era for investors, with market sentiment driven by an optimistic consensus that "returns will eventually be realized, just waiting for the right timing."

Compared to the valuation levels at the end of the 1990s, the current free cash flow yield of median large-cap stocks in the S&P 500 index is significantly higher than in 1999, while the price-to-earnings ratio adjusted for profit margins is at a discount of about 40% compared to that time. Wilson believes that the core competitiveness of today's market is more prominent: stronger free cash flow generation capabilities, higher operational efficiency, and more solid profitability, all of which indicate that the quality of the current market has surpassed that of the internet bubble period.

Regarding the turning point of the economic cycle, Wilson judges that April 2024 marks the low point of the rolling recession that began in 2022, officially starting a new cycle. Such turning points are usually accompanied by a significant expansion of price-to-earnings ratios, as the market expects future earnings to recover. The current V-shaped recovery trend in earnings revisions strongly suggests that next year's earnings expectations may be overly conservative, thus justifying a higher price-to-earnings ratio.

On the liquidity front, although the market holds an optimistic view on cyclical momentum for 2026, the Federal Reserve is likely to continue cutting interest rates, primarily due to the lagging effects of labor data. The latest ADP report shows that the job market remains weak following tariff disruptions at the beginning of the year, and moderately weak employment data is actually beneficial for the stock market—this provides room for the Federal Reserve to continue cutting rates until 2026.

In terms of industry allocation, Wilson believes that the healthcare sector offers an attractive risk-return ratio. Specifically, the earnings revisions in the pharmaceuticals/biotechnology and equipment/services sub-sectors are accelerating, and their relative valuations are at historical lows.

Historical experience shows that the biotechnology sector performs strongly during the Federal Reserve's interest rate cut cycles, often benefiting from declining back-end yields. Recently, this sector has shown positive signals: driven by the Trump administration's most-favored-nation treatment and drug pricing policies, it has recorded its strongest weekly performance (a 7% increase) since 2022.

The resolution of key clearing events (such as most-favored-nation treatment and drug tariffs) has attracted versatile investors back to the sector after a prolonged slump. Wilson concluded that given the relative valuation of the healthcare sector is still in the bottom 5% of its historical level over the past 30 years, its likelihood of continuing to outperform the market is high