U.S. Investors Overly Optimistic in Stock Market

Economic Growth Weaker Than Expected, According to Chief Investment Officer

U.S. investors have been overly optimistic in their outlook on the stock market, according to Michael Wilson, Morgan Stanley's chief investment officer. Despite weaker-than-expected economic growth, the recent rally has fueled investors' beliefs in a meaningful re-acceleration of growth this year, particularly for the consumer sector. However, Wilson disagrees with this sentiment, citing slowing Personal Consumption Expenditures (PCE) growth and concerns over a potential recession.

Wilson and his team acknowledge that it is common for investors to alternate between expecting a soft or hard landing when the Federal Reserve is approaching the end of its interest-rate hiking cycle. However, there is widespread skepticism about a soft landing, where the economy avoids a recession. This skepticism is due to the assumption that a soft landing is now the expected outcome.

The PCE index experienced a significant slowdown in the second quarter of 2023 and continues to weaken based on recent feedback from retailers and an increase in delinquencies. In light of these indicators, Morgan Stanley economists predict that real PCE growth will decline in the fourth quarter, with nominal PCE growth reaching just 1.3%.

While the inflation measure closely monitored by the central bank slightly increased in July, it aligns with economists' forecasts. The cost of goods and services rose by a modest 0.2% in July, resulting in a year-over-year inflation rate of 3.3% compared to 3% in June.

Wilson believes that many stocks and investor expectations do not account for potentially weaker September and October data. If this data reveals a slower economic performance, it could impact the stock market negatively.

See: Stock-market investors celebrate soft data. Here's when bad economic news becomes bad news for Wall Street.

Artificial Intelligence Excitement Influencing Investor Sentiment

Investors' sentiment can be greatly influenced by stock prices, especially when there is excitement surrounding artificial intelligence (AI). This excitement has expanded from a select few beneficiaries to the broader U.S. stock market, leading to a rally in small caps and other economically sensitive sectors such as financials, materials, and industrials.

However, this rally was short-lived, as small caps and cyclicals underperformed after reaching their early February highs. According to Wilson and his team, these failed rallies may raise doubts among market participants who were hoping for a more widespread stock rally and a soft landing or growth re-acceleration.

Despite recent optimism fueled by the rally in some major averages, underlying weakness in breadth and cyclical areas of the market suggests caution is necessary. Wilson and his team believe that this cautious sentiment should outweigh any temporary feelings of positivity.

On Tuesday, U.S. stocks were trading lower after experiencing strong weekly gains on Friday. The S&P 500 was down 0.3%, the Dow Jones Industrial Average was down 0.4%, and the Nasdaq Composite remained nearly flat.