3 reasons for continued bullishness

by Denise Chisholm, Director of Quantitative Market Strategy, Fidelity Investments

Fidelity strategist Denise Chisholm sees more room to run.

Despite taking a breather in April, the stock market has overall continued to rally this year—extending the bull market that began more than a year ago.

My research focuses on analyzing market history to uncover patterns and probabilities that can help inform the current outlook. Recently, my research has suggested that broad-based stock gains could continue, fueled by strong corporate earnings, momentum, and reasonable valuations. My research has also turned up bullish signals on small-cap and mid-cap stocks in particular.

Here's more on 3 key reasons why I'm still bullish.

1. The corporate earnings outlook appears strong

At the start of 2024, I wrote that corporate earnings looked likely to accelerate this year after struggling in 2023. At that time, I noted that increased pricing power and rising productivity could boost profits. New evidence adds support to this thesis.

For one thing, new manufacturing orders have risen sharply—as shown by the ISM Manufacturing New Orders Index, which uses survey data to measure new orders placed by customers with manufacturing firms. The increase in this index over the 6 months through March was in the top 10% of its range since 1968. Strong growth in new orders may reflect economic expansion, which in turn could boost corporate earnings. In fact, in historical periods with top-10% gains in the ISM index, corporate earnings grew over the next 12 months 92% of the time.

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Another potential boost for corporate earnings could come from loosening lending standards. The Fed's Senior Loan Officer Opinion Survey has shown that on average lending standards have still been tight—but that the rate of change in tightening has shifted dramatically, which could point to potential loosening ahead. The most recent report included a steep 6-month decline in the number of senior bank officers who reported tightening their standards for commercial and industrial loans to large firms.¹ After every comparable 6-month decline since 1990, earnings then grew over the next 12 months.

Finally, forecasts for tech-sector profits offer another reason for optimism about broad-market earnings. As of March, analysts' 12-month earnings estimates for technology companies were more than 25% higher than they were a year earlier. Tech earnings forecasts historically have been a bellwether: Big jumps in earnings estimates for the sector have preceded strong earnings for the market overall. In the past, when growth in technology forward earnings per share reached the top quartile of its historical range, as it did recently, the broad stock market's earnings increased over the next 12 months every time.

2. Valuations and momentum point to more runway for stocks

The stock market has risen rapidly since October 2022 and notched a number of new all-time highs this year, causing some investors to worry that stocks have become too expensive. To gauge equity valuations, I like to compare the market's earnings yield—earnings divided by price—to bond yields. When stocks' earnings yield is higher than the yield on the 10-year Treasury, it suggests to me that stocks are cheap relative to bonds.

Based on this analysis, stocks do not look expensive compared to bonds. Stocks' earnings yield relative to the yield on the 10-year Treasury recently stood near the middle of their historical range going back to 1962. From similar levels in the past, the S&P 500 advanced about 74% of the time over the following 12 months.

What's more, momentum may be on investors' side. Earlier this year, the stock market's gains over a 15-week stretch reached the top 1% of 15-week periods since 1951. Strong momentum like this has been a positive signal, historically. In the past, when the S&P 500 posted a 15-week gain in the top 1% of its historical range, it advanced over the next 12 months 98% of the time.

3. Small- and mid-cap stocks look undervalued

While I think the stock market broadly could still have more room to run, I feel particularly bullish about small- and mid-cap stocks, which have not rallied as much as large caps in the past year and a half.

Small caps' valuations relative to large caps recently reached the cheapest 5% of their historical range, based on the price-to-book ratios of the Russell 2000 and the S&P 500 (price-to-book is stock price divided by book value, which is measured as assets minus liabilities divided by the number of shares outstanding). Historically, that has been a great sign for small-cap performance: Every other time since 1990 that small-cap valuations were in the cheapest 5% relative to large caps, small-cap stocks outperformed over the next 12 months.

Investors who are interested in this opportunity but worried about the potentially higher risks of small caps could consider mid caps instead. Mid caps' relative valuations look similar to small caps', with the earnings yield on the mid-cap-focused S&P 400 recently reaching the cheapest 10% of its historical range, relative to the S&P 500. After similar relative valuation levels in the past, mid-cap stocks outperformed large caps by an average of 15 percentage points over the next 12 months.

In conclusion

Based on my analysis, the environment today looks likely to support further stock-market gains. Investors looking to make tactical adjustments to their long-term portfolios might consider nudging up their exposure to small- and/or mid-cap companies.

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