Still room to move higher in AI trade, says Morgan Stanley's Sherry Paul

Key Concepts

• End-of-Year Melt-Up: A scenario where market prices rapidly increase towards the end of the year, driven by positive sentiment and momentum.
• AI Bubbles: Concerns that valuations for companies involved in Artificial Intelligence are inflated and unsustainable.
• All-Time Highs: Instances where market indices or individual stock prices reach their highest recorded levels.
• Cash on the Sidelines: A significant amount of capital held in cash or cash equivalents, indicating potential future investment.
• Earnings Revisions: Adjustments to analysts' forecasts for a company's or market's future earnings, often indicating improving fundamentals.
• Corporate Tax Cuts and Deregulation: Government policies aimed at reducing corporate tax burdens and easing regulatory restrictions, expected to boost corporate profits and investment.
• M&A Activity: Mergers and Acquisitions, an indicator of corporate confidence and growth strategies.
• AI Innovation as an Accelerant: The idea that Artificial Intelligence is a fundamental driver of growth and efficiency across various sectors.
• Conditions for "the Shoe to Drop": Economic or market indicators that would typically precede a significant market downturn.
• Taking Money Off the Table: The act of selling investments to realize gains, often to fund specific life goals or manage risk.
• Indecision: A state of hesitation in investment decisions, identified as a "killer of returns."
• Inflation: The rate at which the general level of prices for goods and services is rising, also identified as a "killer of returns."
• Idea Maturity Time Horizon: A framework for portfolio allocation that considers the stage of development and growth potential of different investment ideas.
• All-Time Correlations: A situation where different asset classes or stocks move in unusually similar directions, potentially reducing the effectiveness of traditional diversification.
• Mathematics of Diversification: The principle that spreading investments across various assets reduces overall portfolio risk.
• P/E Ratios (Price-to-Earnings Ratios): A valuation metric comparing a company's current share price to its per-share earnings. "Stratospheric P/Es" refer to extremely high ratios.
• J-Curve Trend: A pattern of growth where an initial period of decline or slow growth is followed by a sharp, explosive upward trajectory.
• Rebalancing: The process of adjusting a portfolio's asset allocation back to its original target weights, often by selling assets that have performed well and buying those that have underperformed.
• Bandwidths: Defined ranges or limits within which asset allocations are allowed to fluctuate before rebalancing is triggered.
• Over Your Skis: An idiom meaning to take on too much risk or commitment, exceeding one's capacity.
• Large Market Cap: Companies with a high total market value of their outstanding shares.
• Large Balance Sheets: Companies with substantial assets and financial strength, providing "dynamism" and "liquidity."
• Dynamism: The ability of a company or market to adapt and grow.
• Liquidity: The ease with which an asset can be converted into cash without affecting its market price.

Current Market Outlook and Supporting Factors

Sherry Paul, Private Wealth Advisor and Senior Portfolio Managing Director at Morgan Stanley, expresses a highly bullish outlook on the market, suggesting a potential "super melt-up" scenario. She highlights that the market has already achieved 30 new all-time highs this year alone, possibly reaching 31 today. Paul dismisses concerns about an impending market downturn, stating, "we just don't have those conditions for the shoe to drop."

Her optimism is underpinned by several key economic and market indicators:

• Significant Cash on the Sidelines: Approximately $5 trillion is currently sitting in cash, representing potential capital ready to enter the market.
• Low Unemployment: The labor market remains strong, indicating economic stability.
• Upward Earnings Revisions: Corporate earnings forecasts are improving, suggesting robust company performance.
• Impending Corporate Tax Cuts and Deregulation: A new tax bill is expected to kick in by January, promising corporate tax cuts and deregulation, which historically boost corporate profitability and investment.
• Heating M&A Activity: Increased merger and acquisition activity signals corporate confidence and growth.
• AI Innovation as an Accelerant: Paul views AI as a powerful accelerant across all sectors, driving further innovation and growth. She asserts, "just because markets are going higher doesn't mean they're not going to continue to do so."

Addressing AI Bubble Concerns and Valuation

Paul directly addresses the prevalent discussion around "AI bubbles" and high P/E ratios. She recalls that similar concerns were raised two years ago in 2022 regarding the "stratospheric type P/Es" of what are now considered "AI innovator stocks." However, she notes that "the earnings came through and we saw the P/s go down," demonstrating that strong earnings growth can justify high valuations.

She advises against being "myopically focused on P/E ratios in these radical moments of innovation," suggesting that the trend could follow a J-curve, characterized by an "explosive sort of setup" after an initial period. Paul emphasizes that investors should not miss the opportunity presented by ideas that "are going to accelerate and consolidate very rapidly over the next few years."

Investment Strategies for Individual Investors

Paul outlines distinct strategies for different investor profiles:

1. For Investors Who Have Benefited: For those who have seen significant gains in recent years, the strategy involves "taking money off the table" to fund specific life goals. This includes:

   • College plans
   • Wedding accounts
   • Utilizing tax deductions
   • Contributing to donor-advised funds
   • Taking gains in a way that materially benefits their overall life money plan.

2. For New Clients or Those Who Missed the Market: For investors who have not participated in the recent market rally, Paul stresses the importance of building well-allocated portfolios. She warns that "indecision is a killer of returns and so is inflation." Portfolios should be constructed across what she calls the "idea maturity time horizon," acknowledging that traditional diversification principles ("the mathematics of diversification") are stretched due to "all-time correlations" in the market.

3. General Portfolio Management in a Fast Market: Paul highlights rebalancing as "your best friend" in a rapidly moving market. She recommends having a strategy with "bandwidths" for allocation, ensuring that investors are "taking money off the table, reordering it into a portfolio in a way that you're not too over your skis." This approach helps manage risk and maintain desired asset allocation without being overly exposed to any single area.

Preferred Market Segments

Paul advises investors to focus on companies with "large market cap" and, crucially, "large balance sheets." She explains that large balance sheets provide "dynamism and liquidity," which she considers "one of the most crucial ingredients" for success in the current environment.

She specifically mentions that sectors like Tech, Industrials, and Financials have "largely worked" and have seen "record highs" over many months, indicating her continued preference for these areas.

Conclusion

Sherry Paul presents a compelling case for continued market strength, driven by robust economic fundamentals, significant cash reserves, and the transformative power of AI innovation. She advises investors against waiting for a market correction, emphasizing that conditions for a downturn are not present. Instead, she advocates for proactive portfolio management, including strategic profit-taking for life goals, disciplined rebalancing to manage risk, and building diversified portfolios focused on strong companies with large market caps and healthy balance sheets, particularly in sectors like Tech, Industrials, and Financials. Her core message is to embrace the current market momentum while employing smart, adaptive investment strategies.