Jurrien Timmer: Summer Squall (w/o August 12, 2024)

by Jurrien Timmer, Director of Global Macro, Fidelity Investments

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A Trifecta of Catalysts for a 10% Correction

And just like that, we went from a 10 VIX to a 66 VIX and back to 20.  Happy summer of 2024, everyone, when “stranger things” happen on an almost daily basis.  For the stock market, the catalysts were threefold, starting with the rotation out of the Mag 7, followed by weaker econ data sparking fears of a hard landing, to the icing on the cake in the form of a massive unwinding of the Yen carry trade.

As of the low on August 5th, the S&P 500 index has corrected 10% from the July 10th high.  Despite the outsized reading of 66 for the VIX, the weekly range only reached 5%, which is modest by historical correction standards.  But underlying that spread was a great deal of intra-market churn.

Was that all of the correction or just the start of something more sinister?  Nobody knows, of course, but my sense is that the bull market is not over yet but has reached a more mature and choppier phase.  Let’s review the evidence.

The Pros

Despite the sharp 10% correction and 66 VIX, the S&P 500 cap-weighted index remains in an undeniable uptrend with decent breadth (69% of stocks above their 200-day moving average).

Even the left-behind equal weighted index looks OK, although all the breakout attempts have thus far been rejected.  But we don’t have a string of lower highs and lower lows yet.

And even small caps, which staged an impressive rally as the Mag 7 were rotated out of, is only back to its “scene of the crime” (i.e., the breakout point).

Also, while these sudden 10% squalls can be unsettling, it’s worth remembering that 10% corrections have happened 50% of the time.  Those drawdowns (and bigger ones) are the price that investors must pay to compound their investments at the average 11%.  Those compelling returns mostly can only go to those who don’t sell.

While the unwinding of the carry trade was a major component of the drawdown, which by definition meant that the dollar would decline (at least against the Yen), the fact that the dollar is declining at all is to me a sign that there isn’t a lot of stress in terms of liquidity.  Typically, the dollar would rally at times of elevated volatility, but that was not the case last week.  That suggests to me that this was merely an unwinding of carry trades and not the start of a liquidity or funding crisis.

Another positive is that earnings are not only growing, but accelerating.  Q2 earnings season is almost done, and while there were some notable misses, for the most part the season went as expected.  The year-over-year growth rate has predictably bounced by 400 bps, from +9% to +13%, and with 455 companies reporting, 79% have beaten estimates by an average of 406 bps.  Par for the course.

Between rising earnings growth and falling prices, valuations are coming down.  The cap-weighted forward P/E ratio has fallen by 210 bps to 19.6x as of last week’s low.

And while the trailing cap-weighted P/E multiple remains elevated at 23.4x (down from 24.6x), the trailing equal-weighted P/E ratio remains reasonable at 18.0x.

And that 18.0x multiple is not much higher than the 16.3x multiple that the discounted cash flow model (DCF) spits out when you assume 6% earnings growth and a 5% equity risk premium.  Excessive valuation is often cited as a major problem for the US stock market, but for the majority of stocks it’s really not an issue.

On the rate side, while rate cuts can be a double-edged sword when done for the “wrong” reasons, the Fed now has a clear license to ease, which means that the cost of capital is about to decline for both businesses and homebuyers (and the Treasury).  All my iterations of the Taylor Rule suggest that the Fed can cut to at least 4%, and possibly lower if recent disinflation trends persist.

That’s also good news for bonds, which follow the forward curve, among other things.  But as we saw last week following a sloppy Treasury auction, Government bonds will likely remain valuation-challenged in this era of fiscal dominance.  As a result, I think it will be difficult for longer-dated Treasuries to venture much below a 4-handle.  But at least they are once again negatively correlated to equities.

Cons

It’s never all good, of course, and it’s important to consider the negatives as well.  For one, as we saw in July, the mega caps have become so mega that wherever they go, the headline indices will follow.  So, if this is the start of a lasting rotation and broadening, recent history suggests that it could well be in a declining market, or at least not a rising market.

The chart below illustrates this.  The mega caps are highly correlated to the overall index, and when they go down and also under-perform, the market usually goes down with it.  That’s the orange section below, and it’s what has happened in recent weeks.

It's a bit counter-intuitive that the market could broaden as it goes down, but that’s what happened during the unraveling of the dot.com bubble.  I don’t believe we are in for a repeat of that mega bear market, in part because valuations are not as stretched, and also because the market is much less narrow now.  But still, it’s an important analog to keep in mind.

The big question is whether this is indeed a major unraveling of the mega growers, or just a squall on the way to new highs.  I don’t have the answer, but it’s worth noting that the performance of the Mag 7 and NVDA in particular is on par with past parabolas.

However, whenever you see a “bubble” chart like the one above, remember that these analogs are cherry picked to show parabolic moves that eventually implode on themselves.  Not all parabolas do that (or at least not right away), and in the chart below to help illustrate this I have added AAPL starting in 2009 (dotted black) and 2019 (dotted grey).  In both cases, AAPL just kept going to new highs.  So, it is possible that NVDA and the Mag 7 has more life left, the current rotation notwithstanding. But as a general rule, when a stock or index goes parabolic, it’s best to not get too complacent.

Another counterpoint is the duration and magnitude of the current cyclical bull market.  While on the surface this one is still relatively young at 22 months (the median bull market has lasted 30 months and produced a 90% return), those that occurred during soft landings have tended to be shorter and shallower than average.  The 1994-1998 cycle was the glaring exception, but the 1998-2000, 1966-1968, and 2016-2018 cycles were all relatively modest in scope and length. Perhaps we are already in the 8th inning?

Especially the 1966-1968 and 1998-2000 cycles ended pretty badly.  I don’t expect a repeat, but the analogs are pretty tight.

Another mild negative is that we are now in the seasonally “wobbly” time of year, lasting from August through the first half of October.

Finally, per the Presidential cycle (which holds that years 3 and 4 are the strongest), we are now in month 8 of the 4th year, which suggests that most of the tailwinds are now behind us.

In Conclusion

The typical bull market has spanned 30 months and produced a 90% price gain.  So far, we are at 22 months and 61% (at the recent peak).  So, statistically speaking I don’t want to bet against the bull (yet).  The market has historically spent half its time in a 10% drawdown, and for most stocks, valuations are not extreme.  Earnings growth is accelerating and the cost of capital is coming down.  As long as we are not at the start of a recession, there really isn’t much not to like about the average stock.

But cycles age just like we do, and the bullish case is less compelling than it was a few months ago, in no small part because the market leaders have become so large that wherever they go, the headline indices could well follow.

My educated guess is that the cyclical bull market has reached a more mature and choppier phase, with less upside and more corrections (in technical terms we call these distributions).  With the seasonally wobbly period now upon us, that chop could well continue into the fall.

But ultimately, I think this is a summer squall and not the start of a winter storm.  Stay balanced (in the market and in life), and remember that the stock market’s double digit long-term return accrues to those who can ride out the occasional squall.

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Footnote:

"Summer Squall: Week of 8/12/24 | LinkedIn." 14 Aug. 2024, www.linkedin.com/pulse/summer-squall-week-81224-jurrien-timmer-ngcye/?trackingId=cgiJoMPBpB1ZuVd7gzT9ow%3D%3D.