by Jurrien Timmer Director, Global Macro, Fidelity Investments
Key takeaways
- The direction the stock market may take now is not as clear as it was at the end of March. There are some things working in favor of stocks going upāand also against them.
- On the plus side, earnings look better than expected so far and monetary policy has provided liquidity and support for the recovery.
- Indicators of internal strength in the market and investor sentiment are also holding up. And, last but not least, there is some optimism around treatments and vaccines for COVID-19.
- Some of the negatives include the increasing spread of the virus in parts of the US and the potential damper that could put on the recovery as businesses continue to struggle. And there may be uncertainty with an election coming up.
If there ever was a pivotal moment for making a call on which direction the next 10% or 25% move will be for the S&P 500, now is it, I believe. A few months ago, it seemed to me, it was a relatively simple call, at least based on the study of market history. The stock market typically rallies after the type of historic selling climax experienced in late March, and this time has not been any different so far. But after a 46% rally (which never produced a retest) I think it's much more of a toss-up now.
You only have to look at the chart below to see how virtually identical rallies (in scope of both price and breadth) off a major momentum low can end up going in totally different directions. (Market breadth is a measure of the internal strength of the market, comparing the number of rising vs. declining stocks.)
There is literally nothing in the robust behavior of price and breadth and momentum since the March 23 low that allows me to rule out a bearish outcome, other than the knowledge that since the 1929ā1938 period it has not happened.
We are at that fork in the road now. If I line up the pros and cons, I can fill an entire page with both. So letās review the evidence, shall we?
The positives
On the plus side, the economy has bottomed and is recovering, with earnings growth following along.
Earnings season is looking good so far, with 85% of companies beating estimates by an average of 15 percentage points.
It's still early days for earnings season with 181 companies reporting, and the differences between estimates and reported earnings are unusually large given how little guidance there has been on the earnings front. Just look at the chart above to see the large swing from last week to this week.
But with the 2022 consensus estimates 13% below their February peak and the S&P 500 Index (SPX) only 5% below, a lot needs to go right for current levels to be justified.
Policy response has been another plus, of course. The Fed is keeping its foot on the monetary gas pedal, and more fiscal relief may be on the way as well, as transfer payments threaten to dry up.
The promise that the Fed and Treasury (and their global counterparts) can build a bridge across the COVID-19 abyss and on to the other side of this pandemic has been an important factor behind the market's powerful rally.
The policy response is a major reason why, for now, I continue to assume that the 1929 vs. 2009 chart at the top of the page will end up following the more benign analog (2009).
Part of the policy response and the return of animal spirits to the markets is a robust downtrend in the dollar. The Fed is the world's central bank, and it is doing its part in keeping the world economy supplied with all the dollars that are needed.
The tape (momentum and breadth) has been another plus for the US market. Naysayers will blame the entire rally on a handful of mega-cap FANG* stocks, but the truth is that despite their lopsided performance this has been, for the most part, a broad-based rally.
Yes, the breadth has waxed and waned, but on June 8, some 98% of stocks were above their 50-day moving average. The dispersion has widened again in recent weeks but last week when the FANGs reversed lower, the rest of the market picked up the slack just in time.
One way to debunk the narrow-breadth myth is to simply point out that while the cap-weighted S&P 500 Index (SPX) has gained 46% from the March low, the equal-weighted version of the S&P 500 Index (SPW) has gained 49%. That would not have happened if the rally was entirely dominated by a handful of stocks. (The cap-weighted index is arranged by company sizeāthe stock of the largest company makes up a bigger proportion of the index than the stock of the smallest company. In the equal-weighted index, each company is given an equivalent standing.)
The sentiment picture is another positiveāit's more or less neutral despite the 46% gain. The CNN Fear and Greed Index is at high-neutral, and fund flows do not show any FOMO (fear of missing out).
The one area of sentiment that seems to reflect momentum-chasing appears to be coming from the more speculative cohort within the day-trading crowd. In the past, retail speculation has often turned out badly (think of the tech-driven retail bubbles of 1968 and 1999), but that doesn't mean that it can't continue to drive markets higher over the near term.
Finally, on the plus side, there appear to be a number of potential positive developments underway in terms of COVID-19 treatments and vaccines. This prospect, along with the Fed, have put a floor under the market, including the more economically sensitive "reopen" sectors.
The negatives
COVID-19 continues to burn its way through sections of the US and the world, and this is causing some states to delay or reverse their reopening plans. As a result, some of the high-frequency economic indicators are suggesting that the economy is starting to stall out following the initially strong V-shaped recovery.
This is a problem, because the longer it takes for the economy to heal from the coronavirus crisis, the more permanent the insolvencies are likely to get. The longer the recovery gets dragged out, the greater the risk that this V could turn into a U or L, and that the liquidity crisis that the Fed was able to mitigate will turn into a solvency crisis not unlike 2008.
From my perspective, the risk is not that the economy will not recover, just that it won't recover back to its full potential. If the economy recovers, but only to say 70% of what it was pre-COVID, then it will be a long slog back to normal. Right now, the stock market seems to be priced for something quicker.
On top of this we have a pivotal election in a few months, bringing with it various potential policy outcomes, which could eventually affect corporate taxes and US-China relations.
And then there are the technical divergences against the most recent highs. Here you can see that at last week's high only 82% of constituents were above their 50-day moving average, as compared to 98% at the June 8 high. It may be nothing, but it is worth flagging.
In conclusion
I think the positives continue to outweigh the negatives, and therefore I remain constructive on stocks and other risk assets in general (as I have been since late March). But my conviction is much lower now than it was a few months ago when market history told a more consistent story. Now we are truly at a fork in the road, with what may be a more binary set of outcomes.
For me, that means considering a well-diversified portfolio of both growth stocks and deep value stocks (especially emerging market and non-US developed), gold and Treasury Inflation-Protected Securities (TIPS), and long-duration bonds. A portfolio similar to this, in my view, is pretty close to an all-weather portfolio.
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About the expert
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.
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