by Jurrien Timmer, Director of Global Macro, Fidelity Investments
Happy Birthday
This cyclical bull market was born exactly two years ago on October 13th, 2022, and fitting with that milestone the major averages notched another all-time high last week. Since the start of the bull market, the cap-weighted S&P 500 index has now gained 68%, while the equal-weighted index is up 46% and the Russell 2000 is up 36%. The MSCI ACWI index is up 62%, MSCI EAFE is up 57%, and the MSCI EM index is up 42%. The Bloomberg US Agg index is up 11% and the Bloomberg T-Bill index is up 10%. Gold is up 60%.
A pivotal election notwithstanding, we are now exiting the weakest seasonal period of the year and entering the typically more robust November-April period. While the mega caps have continued to churn, the broad market has continued to quietly make new highs. Higher highs and higher lows are what make a bull market, and thatâs what the bottom 490 stocks have been doing.
The question, of course, is how many more innings there are left in this cycle. The median bull market lasts 30 months and produces a 90% gain, so by that measure we are in the 7th inning or so. While it can be argued that the cap-weighted S&P 500 index is well above its trendline and trading at excessive valuations, these conditions can continue for some time without a catalyst. Meanwhile, 80% of stocks in the index are above their 200-day moving average (i.e., in long-term uptrends).
At the same time, the equal-weighted index quietly continues to notch new highs as well, and is once again almost perfectly correlated with the broader averages following that intense rotation back in July.
A Potent Combo
A major factor driving the robust returns is the one-two punch of growing earnings and rising valuations. Usually, these two drivers move in the opposite direction of each other (as price leads earnings), but once in a while we see them move in tandem. When that direction is down, we get a perfect storm of falling P/E ratios and falling earnings, producing super-bears like 2008 and 2001 (each declining more than 50%). But when they move up together, we tend to get soft landing Goldilocks rallies as seen in 1995 and 2016. Weâll see if it lasts, but so far, the market has been having the best of both worlds.
Q3 earnings season starts now, and consensus estimates are fairly muted with an expected growth rate of only +4%. If the typical bounce happens, we could see growth in the high single digits, which would be below the Q2 growth rate of +14%. That suggests a peak in earnings growth for this cycle.
While the trailing cap-weighted P/E ratio remains elevated at 24.9x (and making new cycle highs), the equal-weighted index remains more reasonable at 19.4x. Itâs not cheap by any means, but itâs not at nose-bleed levels either.
Valuation: in the Eye of the Beholder
Based on a long-term earnings growth rate of 6%, at the current implied equity risk premium (iERP) of 3.6% the market is worth 24.6x trailing earnings (per the discounted cash flow model, or DCF). If we swap that 3.6% iERP for the historical average of 5.0%, that P/E ratio falls to 16.7x. At 19.4x, the equal-weighted P/E-multiple sits squarely in the middle.
How low is an iERP of 3.6%? Per the chart below, itâs definitely on the low side of history. Like beauty, valuation is in the eye of the beholder, and the market evidently feels that equities donât need to out-perform the risk-free asset by more than 360 bps.
The DCF model is both elegant and frustrating, because it tries to incorporate earnings, interest rates, and sentiment (the iERP is essentially a sentiment indicator) into one question: what is the market worth? The DCF is extremely sensitive to changes in the risk premium, as the table shows below. A change of 100 bps in the cost of capital would lift or lower the fair value P/E ratio by more than 5 points.
Part of the valuation story is the level and consistency of how much of earnings get returned to shareholders. For the US, the payout ratio (dividends + buybacks as a share of earnings) has been consistently above 70%, earning it among the highest valuation around the world. As long as this continues, US equities will look expensive.
Donât Fear the Election
The election is coming up in just a few weeks, and the markets seem to be pricing in a higher probability of a Republican sweep. Â While the national polls still show the Democrats leading, polls for the swing states as well as the betting markets are showing renewed momentum for the Republicans.
The table below shows that the two most favorable outcomes for the markets over the two years following the Presidential election are a Republican sweep and a Democrat President with a divided congress. Those seem to be the most plausible outcomes for this cycle, which may be one reason why the markets have taken this election season in stride.
Over the full four years of an election cycle, it makes virtually no difference who wins or loses. US GDP is close to $30 trillion (global GDP is $105 trillion), and the US stock market is worth $50 trillion. Those are big numbers that are not easily swayed by election outcomes.
The 4-year Presidential election cycle remains bullish into year-end, and continues to grind higher in year one of the next term, albeit at a below-average pace (year two is the weakest of the four). So, in that sense there could be some momentum left as the next administration takes office.
Having said that, the 4-year pattern for those cycles when the mid-term year was down (as was the case in 2022) show that year â5â tends to be outright corrective. Either way, these two roadmaps suggest some loss of momentum as we enter 2025, the bullish seasonals notwithstanding
The Fed
Part of the above-mentioned one-two punch of rising valuations and rising earnings is the Fedâs tentative success in landing this plane without crashing it. The chart below highlights this. The pandemic-era excess demand for labor has been completely worked off without elevating jobless claims or causing a downturn in the Fedâs weekly economic index. Â If the Fed can stop the pendulum here, this cycle could go down as a rare success.
Following the recent strength in the jobs report as well as upward revisions to GDP, the market has rightfully walked back expectations of a more aggressive easing cycle. If neutral is 3.5-4.0% (100 bps above inflation), thatâs at most another 4-5 cuts from here.
A less aggressive pace of rate cuts suggests a retracement of the recent sharp declines in bond yields. Thatâs happening now, with the 2-year yield climbing back to 4.0% from its recent low of 3.56%. The reversal happened right as the dollar was testing multi-year support at 100, which continues to hold.
As for the long end, thatâs back above 4.0% as well, which is where the 10-year Treasury yield belongs in my view.
If the Republicans are going to sweep in November (and even if they donât), we are likely in for a long regime of fiscal expansion (i.e., sustained large deficits), at a time when the Fed and other central banks are no longer swooping in to buy debt. That that could well change if we are headed for a regime of fiscal dominance (in which the central bank is subordinated to fiscal policy), but so far thatâs not the path we are on. For now, the dynamic of fiscal expansion without monetary easing suggests higher real rates and a positive term premium for long bonds. Bonds are great for coupon clipping, but perhaps not much more.
All About the Liquidity
What happens to the overall liquidity profile in the coming years will tells us a lot about the performance of equities, bonds, gold, and Bitcoin. So far, the Fedâs aggressive tightening campaign of 2022 and 2023 has brought the money supply back to its long-term trendline (which historically rises by 3.6% per year in real terms). Thatâs good news for both monetary and price inflation.
However, with the Fed and other central banks now easing policy while bank reserves remain ample and economic growth is solid, against a backdrop of persistent deficits, it remains to be seen for how long central banks can keep the money supply at bay. Indeed, the global money supply (per Bloomberg) is already at a new high of $107 trillion. Equities tend to follow the liquidity wave, as we can see below.
Gold
Gold is perhaps the purest hedge against monetary inflation, and while the correlation is not perfect, the increase in money supply seems to be a big driver behind goldâs impressive rally.
With real rates coming down (shown on a reverse scale below) and the money supply expanding, gold could be a competitive asset in a diversified portfolio.
Bitcoin
What about that other aspiring store of value, Bitcoin? It too shows a correlation with the global money supply, but it is not making the consistent new highs that gold is. Perhaps it already frontloaded those gains when it recovered from its dip to $15k in late 2022. I see gold and Bitcoin as different players on the same team, so perhaps they are just not both playing right now.
In my view, Bitcoin is a network asset that aspires to have the utility of money. I think of it as exponential gold, or gold with an exponential network feature. But it is as of yet unproven, unlike gold which has a thousand year track record.  For Bitcoin to compete on the store of value team, its adoption curve has to continue to grow, just like the many S-curves that have come before it.
I think of Bitcoinâs price discovery in two ways: one is the shape of the adoption curve itself, and the other is the price pendulum that swings back and forth around that curve. We can see this in the chart below.
Per Metcalfeâs Law, if Bitcoinâs adoption curve continues to grow, its valuation and price should follow suit. But beyond that fundamental anchor, Bitcoinâs price has followed a boom-bust cycle in which it tends to dramatically overshoot and undershoot the underlying curve. This is understandable for a young asset that is still going through price discovery.
But this year that curve has flattened out, with the number addresses with a value of at least $1 all but stagnating at the 46 million mark. Â Perhaps this adoption metric is no longer relevant with the onset of ETFs earlier this year, but the lack of momentum is notable. I will look into the question of how to reconcile ETF flows against the number of BTC addresses and wallets.
If Bitcoin has indeed become a mature asset that is less prone to boom-bust swings, it will be up to the shape of its adoption curve to drive the price further. Perhaps that acceleration is coming soon if the world is heading to a state of fiscal dominance, but for now itâs gold thatâs stealing the show.
This information is provided for educational purposes only and is not a recommendation or an offer or solicitation to buy or sell any security or for any investment advisory service. The views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Opinions discussed are those of the individual contributor, are subject to change, and do not necessarily represent the views of Fidelity. Fidelity does not assume any duty to update any of the information.
Copyright © Fidelity Investments
