Despite narrowing price gains, stocks remain attractive as earnings soar.
by Jurrien Timmer, Director or Global Macro, Fidelity Investments
Key takeaways
- Only 30% of the S&P 500 constituents were trading above their 50-day moving average as the stock market moved to new all-time highs recently. That is a rarely seen signal for market technicians.
- Such narrow advances are unusual and have preceded significant drawdowns in the past. I don't expect that to happen now but, in my view, the current cycle adjustment may continue to produce a sideways trading range.
- On the bright side, 2021 earnings continue to soar, and I remain constructive on equities.
If you have been looking at the tape lately and getting that not-so-great feeling about the narrowness of the advance to new all-time highs, you're not alone. With the leadership firmly back in the hands of the secular growers, breadth has narrowed significantly. The chart below shows that only 30% of S&P 500 (SPX) constituents are trading above their 50-day moving average.
It's an unusual occurrence to see the S&P 500 index at all-time highs while fewer than 50% of its constituents are above their 50-day moving average. In fact, by my calculations the recent signal is only the third one since 1927.
The first one was in June 24, 1998, (just before the Long-Term Capital Management or LTCM top) and the second one was December 21, 1999, (just before the dot.com bubble peak). The first occurrence preceded a 20% drawdown and the second preceded a 53% decline. The third and most recent signal occurred just a few weeks ago.
Now, I'm not expecting a major drawdown like that, but the narrowness of the current advance does fit with the narrative that the market is in a holding pattern as it transitions from early-cycle to mid-cycle, while at the same time the Fed is trying (again) to take the punchbowl away.
In my view, the current cycle adjustment will likely continue to produce a sideways trading range that produces only modest swings at the index level but plenty of rotation and churn beneath the surface.
We saw this happen in 2018 when the Fed led by Jerome Powell was normalizing policy, as well as in 2015-2016 when the Fed led by Janet Yellen was trying to do the same. When financial conditions tighten, the stock market tends to take note.
Perhaps the most classic example of a Fed-induced mid-cycle correction was the "stealth" bear market of 1994, during which the Fed led by Alan Greenspan doubled short rates unexpectedly (no dot plot back then). The adjustment period lasted 9 months and produced 2 small drawdowns of 10%, but beneath the surface many stocks got clobbered.
Something similar seems to be happening now during the current counter-rotation (from value back to growth). Only large-cap growth has been making consistent new highs, while the rest is either correcting or not making much headway.
This all fits perfectly with the "peak reopening" and "peak inflation" themes that I have been highlighting since March. As the chart shows below, back in March the rate of change in the NY Fed's Weekly Economic Index (WEI) peaked at the same time that the year-over-year change in the small/large ratio peaked. Then a few months later the year-over-year change in the value/growth ratio peaked during the same week that the 10-year TIPS breakeven spread peaked.
Another sign that there are cracks in the reflation trade (despite the recent hot inflation print) can be seen in the chart below. Here I show the Bloomberg Commodity index (BCOM) overlaid against the Goldman Sachs (GS) commodity-sensitive stocks basket. It's not apples-to-apples but it shows a nonconfirmation at the recent highs. Nonconfirmation means that the stocks did not produce a new high to match the new high in the index. Just like there was a nonconfirmation in the opposite direction at the March 2020 low. Technicians are always on the lookout for signals like this.
But it's not all gloom and doom for stocks. With Q2 earnings season now underway, earnings continue to soar. With only 39 companies reporting so far, the Q2 growth estimate is already up to 71%.
This is bringing the 2021 calendar-year growth estimate up to 37%.
The early-cycle phase is typically driven by P/E expansion, while the mid-cycle phase is driven by earnings growth. That baton-pass allows for the P/E to come down, but not at the expense of price. I still think this is where we are in the cycle, and remain constructive on equities despite the policy-related concerns that inevitably come with this cycle transition.
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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