by Jurrien Timmer, Director of Global Macro, Fidelity Investments
Key takeaways
- The market's pullback since the start of the year has been most sharply felt in more-speculative sides of the equity market, while less-speculative equities have held steadier.
- On a technical basis, the market now looks oversold.
- 2022 is unlikely to see strong valuation-driven price gains. Instead, price gains will likely hinge on earnings growth.
- We may be in an extended mid-cycle, with modest price gains, but also more wobbles.
When a storm blows through, it's usually better to be on a large sturdy ship than on a dinghy. The markets are definitely going through their own version of a "Small Craft Advisory" these days (a warning the National Weather Service issues to small boats in times of high wind speeds). Stocks that are the most dependent on easy liquidity conditions—and that aren't backed by steady earnings growth—have been reversing most of their pandemic-related gains.
With the S&P 500® approaching the 10% correction threshold, financial conditions are finally starting to tighten from what had been the loosest liquidity conditions ever.
The story of the tortoise and the hare seems like an apt analogy here. The most-speculative sides of the equity market—like nonprofitable tech companies, and companies that tend to be sensitive to the price of Bitcoin—gained the most in the pandemic's first year. But those equities have fallen the most during the recent pullback (while the least-speculative sides of the market are holding steadier), erasing their outperformance since the start of the pandemic.
Markets look oversold on technicals
On a short-term basis, stocks are now the most oversold they have been since March 2020, right as the S&P 500 is testing its 200-day moving average. My guess is that we may have already seen the worst here.
With the index down more than 8% since the start of the year, the percentage of stocks in the S&P 500 trading above their 50-day moving average is down to 32%. This is in line with past wobbles, but still far better than March 2020.
A reset for P/E ratios
The S&P 500's 12-month forward P/E ratio (which compares the index's level against estimated earnings for the next 12 months) has now compressed 2 points since this latest squall started, and 3.4 points since valuations peaked in August 2020.
This makes perfect sense mathematically. As I wrote last year, the Fed's asset purchases and forward guidance had led to an artificially low 10-year yield—the discount rate used for valuing equities.
The good news is that the 10-year yield has gotten a lot closer to its fair value (2-ish percent), now that yields have backed up and break-evens on Treasury Inflation-Protected Securities (TIPS) are softening. So maybe this recent haircut was all that was needed to restore balance to the stock market.
Eye on earnings
For 2022, it is going to be mostly up to earnings to carry the market. It's difficult to envision a market regime in which multiple expansion carries the day, given that fiscal stimulus is no longer a sure thing and the Fed is expected to normalize policy, by bringing the fed funds rate back to at least 2%.
If it's all up to earnings growth, what can we expect in 2022? With fourth-quarter earnings season getting underway, the consensus is for 9% growth in 2022. Based on historical patterns, that may well come down a few percentage points.
If current estimates are correct, we could see a soft landing following the massive 2021 gain (i.e., continued growth but at a moderating pace). This would be a similar outcome to the 2004 and 2010 cycles, which produced extended mid-cycles (the 2018 cycle would likely have been similar had the pandemic not happened).
Based on this expectation, it would seem reasonable to expect ongoing modest price gains in 2022 and 2023, but perhaps with more wobbles.
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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