Financial markets are upside down, says Morgan Stanley, and investors can take advantage

Chief cross-asset strategist Andrew Sheets points out that forward earnings estimates for both global equities, as measured by the MSCI All-County World Index, and the U.S., as measured by the S&P 500, haven’t risen all year. That means the entirety of gains have been driven by higher valuations. Over the last 25 years, he notes, only twice has there been stronger gains in multiples, and both those times, in 2009 and 2020, there were deep recessions met by enormous monetary easing, which supported the case that valuations should rise ahead of an eventual rebound.

Sheets also looked at 1998 and 2019, when multiples rose despite a shrinking Fed balance sheet and falling earnings per share. But core inflation then was about 2%. “Coincidentally, both 1998 and 2019 saw markets trade poorly in August-September, and multiple Fed rate cuts in the back half of the year,” he says.

But the really weird stuff is happening in capital structure, Sheets says, where there’s higher returns on senior debt structures than on the more junior exposures, what he calls unusually upside down.

For example, the yield on investment-grade corporate bonds, of 5.4%, is higher than the forward earnings yield for the Russell 1000, of 4.8% — it’s only been more extreme than that 2% of the time over the last 20 years. Similarly the yield on U.S. investment-grade real estate investment trusts, of 5.8%, is above the average U.S. commercial real estate cap rate, or the underlying real estate yield, of 5.4%. The difference between the yield on a collateralized loan obligation’s collateral and the weighted cost of its liabilities is in the 7th percentile of the last decade, in both the U.S. and Europe.

Sheets acknowledges there are different stories behind these inversions of sorts, and it makes sense for debt to be expensive to its underlying asset if growth is strong. “But this compression, and even flipping, of the capital structure suggests that growth expectations have now moved a long way since the start of the year. Across scenarios where growth stays solid, or slows, we think that debt generally offers better risk/reward, particularly when this capital structure compression provides increasing economic incentives to de-lever,” he says.

The markets

U.S. stock futures
ES00,
+0.14%

NQ00,
+0.17%
edged higher. The dollar
DXY,
+0.14%
was stronger in reaction to disappointing data out of Europe and the U.K.. Crude futures
CL00,
+0.52%
were trading just under $78 per barrel.

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The buzz

AMC Entertainment
AMC,
+1.62%
submitted a revised proposal for its stock conversion plan after a judge rejected a settlement late on Friday, sending its stock up by some 60%.

Warner Bros. Discovery’s
WBD,
-1.37%
“Barbie” saw $155 million in ticket sales from North American theaters, while Comcast’s
CMCSA,
-0.74%
“Oppenheimer” registered $80.5 million — the strongest combination of movie openings on record.

Tesla
TSLA,
-1.10%
was downgraded to neutral from buy at UBS, which says new launches won’t help the company’s results over the next 12 months.

Chevron
CVX,
+1.46%
said its earnings were stronger than forecast as it said long-time CFO Pierre Breber was retiring, while waiving the retirement age for 62-year-old CEO Mike Wirth.

The flash readings of S&P’s manufacturing and services PMIs are due for release at 9:45 a.m. Eastern. The eurozone flash composite PMI fell to an eight-month low of 48.9.

Best of the web

Elon Musk said he’s phasing out the Twitter brand in favor of X, which intends to add payment services to the messaging service.

Jeff Bezos is now paying attention to the newspaper he bought a decade ago.

Sam Altman’s eyeball-scanning crypto project launches.

Top tickers

Here were the most active stock-market tickers on MarketWatch as of 6 a.m. Eastern.

The chart

Good news, lazy investors, courtesy of RBC Capital Markets. Passive funds are outperforming actively managed funds that are benchmarked to the S&P 500. This of course makes some intuitive sense, given the strong gains for the mega-cap technology stocks, which fund managers have a tough time replicating given their mandates to diversify portfolios. But even in the small cap world, looking at funds benchmarked to the Russell 2000, passive also comes out on top.

Random reads

Bidders are snapping up old mall memorabilia.

A 661-pound fish might save its home river.

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