Jurrien Timmer: What will it take to push stocks higher?

Higher valuations are the key to keeping the long-running bull market going.

by Jurrien Timmer, Director of Global Macro, Fidelity Investments

Key takeaways

• With earnings growth decelerating—and at risk of getting downgraded in 2020—the stock market can rally strongly from here only if valuations expand.
• But with the global economy slowing and trade tensions mounting, I find that scenario unlikely for now, leaving the market stuck in its 20-month trading range.
• Relative to bonds, though, stocks appear cheap to me.
• Should bond yields continue to fall, I think a case can be made that the stock market could extend its rally on relative valuation alone.

I have difficulty envisioning a scenario in which, anytime soon, the S&P 500^® stages an upside breakout from its now 20-month-old trading range. The index's earnings growth has steadily slowed from 2018’s torrid and tax-cut infused 22% pace to what I think is likely to amount to a mere 2% growth rate for 2019.

Market expectations are for a recovery to 10% earnings growth in 2020 as well as 2021, but as we close in on year-end, we enter the time frame where investment analysts historically have started scrutinizing their 2020 assumptions more closely. In turn, that likely will kick off the downward earnings-revision drift we usually see over the course of a year (and which I've charted in previous commentaries). So even in a status quo type of environment, experience tells me those 10% estimates are likely to start sliding. But we are not in a status quo environment: We are in a global slowdown compounded by a serious trade war. Based on the latest sub-50 ISM report,¹ including its weak new-orders component, I expect earnings estimates to be revised lower in the months ahead, even beyond the typical seasonal drift that can develop around now.

By my math that means the only way for the market to gain more than 4% over the next year is for valuations to move up from here.

That's possible, of course, but not without some catalyst. That catalyst could have been the Federal Reserve’s deciding to "shock and awe" us with a 50-basis-point cut at its September meeting—coupled with a promise to do more. But instead the Fed has stuck with its mid-cycle correction theme, cutting its benchmark rate by just a quarter point and suggesting no further rate cuts for 2019 and 2020 (versus what had been bond market expectations of 4 more cuts). So, as I see it, the impetus isn't likely to come from the Fed, despite even its subsequent injection of nearly $300 billion (so far) of liquidity into the system.

What else? The US and China could reach a trade deal. But my sense is that even were a deal to materialize, it likely would be limited, not enough to put an end to current international trade disputes.

Of course, we could simply enjoy a general improvement in economic prospects, enough to lift earnings growth back toward trend. But based on the most recent data, I see plenty of downside momentum and few signs of a bottom, so I am not holding my breath on this one either.

On the front line of the economic slowdown and the trade war are profit margins, and those continue to erode for companies in the large-cap S&P 500^® equity index. The profit margin on the MSCI USA Index has declined from its peak of 12.1% in 2018 to 11.7% more recently. That's not the end of the world by any means, but if profit margins don't hold up then it becomes harder and harder to reconcile the divergence between the stock market’s P/E ratio and its price-to-sales ratio.

The S&P 500's P/E ratio is somewhere above normal, but not near historical extremes in my view. However, at 2.2x, the index’s price-to-sales ratio is very close to its all-time high set at the peak of the dot-com bubble in the year 2000.

The difference between these 2 ratios? Profit margins. Rising margins have been a key driver for this now 10-year-old bull market. If that trend goes into reverse because of a trade war—not to mention the stagflation that such a war might produce—then the whole secular bull market thesis could be called into question.

Or would it? The silver lining of the recent plunge in interest rates—with the 10-year Treasury yield, adjusted for inflation, declining from 1.15% at its 2018 high in November to a low of -0.09% this past August—is that it has elevated the earnings-based equity risk premium (in this case, the difference between the S&P 500's earnings yield and the risk-free rate) to 4.5%. That figure is well above the 2% risk premium we have seen in recent years and as high as it was this past December when the S&P 500 was off around 20% from its 2018 high.

In conclusion, from where I am sitting—and barring a surprise from the Fed or an economic rebound—I think the only way the market will be able to move up from current levels in a sustained way is for the equity risk premium to "catch up" to the bond market's term premium, i.e., by falling sharply. (The term premium is the excess yield investors typically expect from holding a long-term bond versus a series of shorter-term bonds.) Based on my recent deep dives on yields, demographics, and secular bull market analogs, I don't consider such a nosedive very likely over the near term, but I also wouldn't bet against it over the long term.

Jurrien Timmer

Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.