by Jurrien Timmer, Director of Global Macro, Fidelity Investments
What was anticipated to be a too-close-to-call election is shaping up to be a decisive red wave, with the Republicans (so far) taking the White House and Senate, and possibly also the House of Representatives.
The perceived closeness of the election likely had kept many investors sitting on their hands, refraining from implementing either a blue or red playbook. The inevitable consequence was that the decisive outcome caused a large market adjustment on November 6, ranging from sector rotation (into consumer, financials, and energy), small cap outperformance, higher equity valuations, lower implied volatility, a stronger dollar, higher real yields, and reduced expectations of Fed rate cuts in 2025.
This large repricing leaves us with the inevitable question of whether we should follow or fade this red wave. Below are my takes. Note that 2025 may be less robust than 2017 as there are likely to be some headwinds that could limit the scope of another 2017-type rally (which produced a 31% return of the S&P index from election day 2016 through 2017), let alone the 39% return over the past 12 months.
Let’s Unpack the Pros and Cons
Con: The immediate aftermath of November 5th was risk-on and vol-down. The VIX (Chicago Board Options Exchange’s CBOE Volatility Index) fell to 15, while high yield credit spreads tightened to 256 bps and the implied equity risk premium (iERP) compressed to 320 bps. This trio of outcomes (seen in the chart below) looks to be a repeat of the liquidity-infused rally in 2021, when the pandemic-induced fiscal impulse was super-charged by monetary stimulus, until the Fed took the punchbowl away in 2022.
Pro: if this is indeed a red wave, the market implications could be favorable based on history (see below). The middle panel shows that since 1900 the 2-year equity return of the S&P 500 following a sweep has been positive 15 out of 19 elections. For just the Republicans, it has been 7 out of 8.
Con: having said that, history shows us that years 1 and 2 of a Presidential cycle have tended to be below-average, while years 3 and 4 are above average. For those cycles in which the mid-term year was down (as was the case in 2022), the market has recovered strongly in years 3 and 4, only to turn sideways in the subsequent year 1. We can see below just how perfect this cycle has been over the past few years, nailing the October 2022 low to the week, and rising ever since. But the cycle tends to peak at year-end and we’ll see if it turns sideways for 2025.
Pro: this bull market is not old. At 25 months young, the cyclical bull market that began in October 2022 remains on-track and on-trend. In contrast, the typical bull market has produced a 90% return over 30 months.
Pro: From a technical perspective, I don’t see anything not to like in the chart below. Yes, the index is above the trendline, much as it was in 2021, but the pattern of higher highs and higher lows is in place, and 75% of the stocks in the index are in long-term uptrends (above their 200-day moving average).
In some ways, this bull market has been the opposite of the standard cycle, which starts broad and gets narrower with age. This one, however, seems to be getting younger with age, broadening as it gets older.
Tops usually happen when breadth diverges from price (see 2021 and 2014), but this hasn’t yet happened in a meaningful way. In fact, as the next chart shows, the number of 52-week highs soared last week in what could be deemed a “breadth thrust.”
Small caps also rallied and are finally back to their previous all-time high set at the end of 2021. The breadth numbers for the Russell 2000 (R2) remain unimpressive, however, and the relative performance remains down vs the S&P 500 (SPX).
Pro: Earnings are growing, and the outlook (according to the data) for the next few years remain positive. The chart below shows that Q3 earnings seasons is progressing exactly in line with the typical quarter, producing a 500 bps bump in the growth rate and a %2.6 bump in the quarterly EPS estimate. With 453 companies reporting, 75% are beating by about 700 bps. Typical.
Below we see that the 2024 calendar year estimate remains stable at $242 (for a 9% growth rate). The numbers for 2025 are coming down, which is typical in a non-inflection year, and the growth rate in the forward estimate appears to have peaked at 14% or so.
This suggests that the earnings cycle may be reaching a more mature phase. Of course, further tax cuts or deregulation could breathe new life into the earnings cycle, but to what extent that will happen or be offset by tariffs remains to be seen.
Con: valuations are pushing the limits, at least on a cap-weighted basis. The chart below shows that both trailing and forward multiples are approaching the 2021 extremes, which was a mini bubble of sorts.
While we know that the P/E ratio is a poor predictor of returns over the short to medium-term, the gap between the average iERP (5%) and the current (3.2%) is as wide as it was in 2021. While a 3.2% iERP is not terrible, it’s above average at the 72nd percentile going back to 1871.
The chart below shows the result of the discounted cash flow model (DCF). Here I isolate earnings growth at 6% and am solving for the iERP. That gap (26.1x vs 16.7x) gets wider by the week. Perhaps a reduced iERP is justified if the risk-free asset (Government bonds) has become “impaired” by a rising term premium (more on this later).
Still, looking at the chart below, which deconstructs the market return into an earnings component and a valuation component, it’s difficult to see the market repeat the performance of the past 12 months without turning into another bubble. The trailing P/E-multiple is up 32% year-over-year while trailing earnings are growing at 8%. If the growth rate is cresting and the cost of capital is rising, it will be tough to see 2025 returns compete with this year’s dufecta of expanding multiples and growing earnings.
Yes, there have been extended periods of simultaneous valuation expansion and earnings growth, and this dynamic could repeat in 2025. However, with a starting P/E of 25x (trailing), the hurdle is much higher than it was in the early-to-mid 2010’s, when valuations were only in the mid-teens. Starting points matter.
Con: the rising term premium. This P/E hurdle is made more challenging by the return of the Fed model. With more growth and ongoing deficits and a Fed that is no longer funding the trillions in deficits that the Treasury is financing, the term premium is understandably rising. It has been suppressed by QE (quantitative easing) and zero interest rates for the past decade-plus, but those days appear to be over.
A rising term premium is likely to cause occasional rate tantrums that push yields to 5%, as we have already seen repeatedly since 2022. When I adjust my bond model for a more normal term premium (100-150 bps), it’s easy to see 5% becoming the new 4%.
More growth and fiscal stimulus are also likely to keep the Fed from cutting rates below 4%. Indeed, the forward curve continues to walk back its expectations for rate cuts, and the curve is now at the top end of the dot plot. It’s a far cry from how the year started.
All of this suggests that the bond vigilantes are back, much as they have been in the UK. It’s the revenge of the Fed model. Rather than equities fearing falling yields as they did over the past two decades, they now fear rising rates, as that lowers the present value of future earnings.
Yes, earnings matter more than rates when computing the fair value, but against a more mature earnings cycle and a high valuation starting point, repeating the outsized returns of the past 12 months and the first year of the first Trump administration will not be as easy as one might conclude from the market reaction on November 6th.
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