The Great Normalization
Reset market expectations as rates, premiums, and valuations return toward history
- Difficulty
- Advanced
- Time to result
- ~months to results
- Steps
- 6
- Confidence
- 96%
The Great Normalization is a regime model for interpreting markets after fifteen years of exceptional monetary support, fiscal stimulus, low rates, and outsized US equity returns. It starts by comparing recent conditions with longer historical norms. Real growth, experienced inflation, and a positive term premium imply a higher normal cost of capital than investors became accustomed to after the financial crisis. As rates normalize, richly valued assets lose some support, valuation multiples may mean-revert, and earnings must do more of the work. Positive capital costs also make management quality, strategy, and company selection more important. The framework does not predict an immediate crash. Instead, it resets assumptions about rates, valuations, diversification, volatility, and expected returns so portfolios are not built on the premise that extraordinary accommodation will continue forever.
Origin
Lisa Shalett presented the Great Normalization as Morgan Stanley's framework for markets moving beyond the unusually accommodative post-financial-crisis era on Masters in Business.
Core principles
- 01Treat the post-2009 market environment as historically exceptional
- 02Anchor expectations to economic growth, inflation, and term premiums
- 03Expect positive capital costs to separate strong companies from weak ones
- 04Allow elevated valuations to normalize through earnings growth or lower multiples
- 05Do not assume US outperformance and policy support will persist indefinitely
How to run it
- 1
Identify the exceptional baseline
Measure how the recent period differed from historical business cycles in returns, rates, stimulus, valuations, and regional performance. Label benefits that depended on extraordinary policy support.
Pro tip Compare full-cycle averages rather than selecting a single favorable decade.
Watch out Do not assume fifteen years of experience represents an enduring norm.
- 2
Estimate the normal cost of capital
Combine expected real growth, experienced inflation, and an appropriate term premium. Use the result to establish a plausible range for long-term rates.
Pro tip Distinguish the Federal Reserve's inflation target from inflation actually experienced over long periods.
Watch out Leaving out term premium can materially understate long-duration yields.
- 3
Reprice valuation assumptions
Examine whether equity multiples and credit spreads still imply near-perfect conditions. Model how expected returns change if valuations move toward historical ranges.
Pro tip Allow for normalization through earnings growth as well as price declines.
Watch out Mean reversion has no reliable short-term timetable.
- 4
Test concentration
Review dependence on US equities, mega-cap technology, a strong dollar, or another dominant source of past returns. Identify exposures that benefited most from the exceptional regime.
Pro tip Compare portfolio weights with global economic and profit shares.
Watch out Diversification should not become an indiscriminate rejection of high-quality US companies.
- 5
Differentiate operating quality
Assess which management teams can allocate capital, finance operations, and execute strategy when money has a meaningful cost. Favor businesses whose economics survive without exceptionally cheap funding.
Pro tip Focus research on cash generation and capital discipline.
Watch out Narrative strength cannot compensate indefinitely for weak economics.
- 6
Reset portfolio expectations
Update expected returns, volatility, diversification, and rebalancing rules for a more normal environment. Communicate that normalization can unfold over several years.
Pro tip Use ranges and scenarios rather than a single forecast.
Watch out Do not convert a strategic regime view into repeated short-term trading.
In the wild
An investor built wealth during the post-2009 period with a concentrated market-cap-weighted US portfolio. Instead of projecting the same return forward, the investor models higher long-term rates, lower valuation multiples, and slower relative US outperformance. The portfolio is gradually broadened across regions, sectors, and assets while retaining companies with durable earnings and disciplined management.
→ Expected returns become more realistic and the portfolio relies less on a continuation of exceptional monetary conditions.
Common mistakes
Treating recent returns as normal
Compounding near fifteen percent during an exceptional period does not establish a sustainable return assumption for future business cycles.
Using normalization as a crash call
The framework describes a multi-year adjustment in rates and valuations, not a precise prediction of an imminent collapse.
Ignoring policy volatility
A data-responsive central bank can create more rate volatility than a central bank providing stable forward guidance.
Is it for you?
Best for
It is best for long-term investors revising allocations and return expectations after years of low rates and exceptional US equity gains.
Not ideal for
It is not ideal as a precise short-term market-timing signal.
From the transcript
“that's two times normal for a business cycle.”
“part of the great normalization is over the next couple of years, we think long rates start to move towards five to six percent”
“multiples start mean reverting a little bit to seventeen.”
From the episode
Wealth Management and the 'Great Normalization' with Lisa Shalett
Lisa Shalett