Timmer: What to make of the market's rally

by Jurrien Timmer, Director of Global Macro, Fidelity Investments

Is it a new bull market, or just a bear-market bounce?

Key takeaways

• With the market up significantly from the lows it touched in June, stocks have now recaptured roughly 50% of the total losses they'd suffered this year.
• Bear-market rallies are difficult to distinguish from bull-market beginnings.
• One clue may be whether the gains cross much above that 50% mark, as this has rarely happened in past bear-market rallies.
• Even if the bear market is over, there may be little earnings or valuation support for stocks to make strong gains from here.

The big question that everyone has been asking lately is: Is this market rally for real?

The S&P 500^® has now gained about 18% since its intraday low on June 17—retracing slightly more than 50% of the decline it had experienced this year.

It's possible this could prove to be the start of a new bull market, and that June 17 will hold up as the bear market's low point. Or, it could turn out that this is just a bear-market rally (i.e., a short-term rally within a longer-term bear market), and that the market still has further to fall, beyond the June lows.

Which scenario it turns out to be is important for investors, because if this is a bear-market rally, it has gone about as far as it will go. A fork in the road is coming, and it may be an actionable one.

Strong momentum behind the rally

On a few measures, the market is now showing strong positive momentum. At the time of the June lows, only 2% of stocks in the S&P 500 were trading above their 20-day moving-average prices. In the past week, that figure has reached as high as 93%.

Other measures, such as the relative strength index and increases in market breadth (which looks at how many individual stocks are advancing rather than declining) also indicate that there is strong positive momentum.

But those measures aren't definitive in distinguishing between whether this is a new bull market, or merely a bear-market rally that is now at an overbought extreme.

How does it compare with historical rallies?

Another lens for comparison is to measure the recent rally against historical rallies—both ones that marked the start of new bull markets, and ones that turned out to be bear-market rallies.

Focusing on the rally's magnitude and speed—an 18% gain over about 2 months—doesn't tell us much. This kind of rally looks very similar to both new bull markets and bear-market rallies, when comparing with market history.

What about the roughly 50% retracement mentioned before? Is it common for stocks to retrace 50% or more of their losses in a bear-market rally, or could that be a sign of something more?

Now we are getting somewhere. The chart below shows each major bear-market rally since the 1920s, and highlights how far—in terms of retracing or recapturing declines—the rally went before it reversed. Here we see that during past bear-market rallies, the retracement never went much above 50% (with the exception of the rally off the post-WWII bear market in the late 1940s).

This is one of the few technical clues out there. If this rally continues much further than it has so far then it is more likely to be the start of a new bull market, because that level of retracement rarely happens during bear-market rallies. However, if this is a bear-market rally, it likely has gone about as far as it will go.

Slowing earnings, rising valuations

All of that said, even if the June lows hold and we don't see any new market bottoms, in my opinion it's not easy to draw a compelling bullish narrative here.

On the one hand, second quarter earnings arguably turned out better than feared. About three-quarters of companies beat their estimates—doing so by an average of about 4%. On these measures, it ended up looking like most quarters.

But underneath, we are seeing some erosion. One reason so many companies were able to beat their estimates is that estimated earnings had already been lowered. Looking ahead, only about 30% of companies are seeing their earnings estimates increase. If one excludes the energy sector, then earnings for S&P 500 companies are only expected to grow 3% for the 2022 calendar year.

It's also important to remember that we still have high inflation, and earnings growth is measured in nominal terms (meaning, not adjusted for inflation). So there is less than meets the eye here. If inflation keeps nominal earnings growth up, investors may start focusing more on whether margins hold up. So far, the operating margin has declined from 13.7% to 13.1%.

To come back to the market's recent rally—with earnings growth slowing, the rally in stocks has been happening purely via valuations (i.e., with investors rewarding a higher price-earnings ratio to a roughly flat level of earnings). And given that the Federal Reserve is not finished yet with this rate-hike cycle, there may be a limit to how high valuations can go.

It seems like the best hope for equities may be that earnings keep growing at mid-single digits, while valuations remain at current levels.

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