The worst of the market's decline may be over. Now we could be in a holding pattern.
by Jurrien Timmer, Director of Global Macro, Fidelity Investments
Key takeaways
- We may have already seen the worst of the market's recent decline.
- Although this near-correction may have seemed sudden, in reality it's been a rational adjustment to the changing interest-rate outlook.
- Valuations such as price-earnings (P/E) ratios have already come down significantly since the market's early-January peak.
- While valuations may have further to fall, the remainder of the compression may happen gradually via earnings growth (instead of suddenly via further price declines).
- In this environment, investors could consider low-volatility, high-quality dividend-paying stocks such as utilities.
It's been quite a few weeks, to say the least. My strong sense is that the worst is behind us in terms of the market's decline, but that it may take some time before we revisit its recent highs. Let's dig in.
Where we are now
The S&P 500® has now declined 9.8%, from its early-January record high to its most recent closing low last week (with a greater decline on an intraday basis). The Russell 2000 has declined more than 20% peak-to-trough.
But as much as this may seem like a sudden development, in fact the market showed warning signs a year ago, with a blow-off and subsequent reversal in speculative small-cap growth stocks. When the liquidity tide goes back out and it's all up to earnings, these are the stocks that get taken out first.
With the market now in a broad-based decline, stocks generally look quite oversold on a technical basis. As I show below, the percentage of stocks trading above their 50-day moving average is now at its lowest level since March 2020 (according to an index of the largest 3,000 stocks that Fidelity tracks).
A sudden reset for P/E ratios
For stocks, it has been a swift valuation reset. The price-earnings (P/E) ratio for the S&P 500 has now fallen almost 5 points since the peak (from almost 24 to around 19). This is what should be happening during this phase of the cycle, and it is happening.
The good news is that it appears that most (but perhaps not all) of this valuation reset is complete. As I have highlighted in the past, the Fed's asset purchases had until recently pushed the 10-year nominal yield about 100 basis points below my estimate of its "fair value" (which I estimate based on break-even rates on Treasury Inflation-Protected Securities). This had a direct impact on equities—increasing stock valuations from where they would otherwise be based on the "fair value" for yields. (Interest rates have a direct, inverse impact on equity valuations via stock valuation models: When rates go up, stock values fall.)
While the stock market may look like a wild roller-coaster ride sometimes, for the most part it has reacted rationally and mathematically to a changing interest rate landscape. The Fed-induced asset inflation is reversing, and this is a good thing for the stock market longer term.
More than one way for P/Es to compress
Although valuations have come down significantly, they remain slightly inflated when compared against a "fair value" for yields. According to my estimates, the stock market has gone from being 6 P/E points overvalued to just 2 points.
We are not out of the woods yet, but we are getting close. I think that we have now seen the worst of the price drawdown. The remainder of the valuation reset can happen more via growing earnings and less via falling stock prices (i.e., P/E ratios could decline even if prices stay flat, as long as earnings continue to grow).
But that doesn't mean that we are about to leap to new market highs. Even after mild drawdowns, it can take up to a year for the market to exceed the previous highs.
For a sideways market, consider utilities stocks
While I don't see much more downside risk for the overall market, I do think that we are likely stuck in a holding pattern for a while. In that case, considering low-volatility, high-quality, high-dividend stocks seems like a good idea to me.
One sector investors could consider looking at is utilities stocks. Over the long term, utilities show poor relative returns when compared with the S&P because of their low beta (which means they generally share in less of the upside and less of the downside of the broader market). But the sector's relative returns are currently far below their long-term trendline. And with the 10-year Treasury now approaching fair value around 2%, while the Fed is tightening and earnings growth is slowing, there is a strong case to be made that the opportunity cost of owning utilities is low.
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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