Jurrien Timmer: Animal Spirits (Dec. 3, 2024)

by Jurrien Timmer, Director of Global Macro, Fidelity Investments

A Thanksgiving Worth Giving Thanks for

I spent Thanksgiving in Manhattan, at the invitation of our friends who live in the storied Dakota building overlooking Central Park (of John Lennon and Rosemary’s Baby fame).  We didn’t get there in time to see the parade go by, but the dinner party more than made up for it.  This remarkable building was constructed during the horse and carriage era (1886), so instead of a grand lobby there’s a courtyard.  From there, it’s 3 foot thick walls, wood paneling, and 15 foot ceilings.

As a naturalized American, Thanksgiving doesn’t quite have the meaning (or baggage) that it has for many, but this one was made very special because both my kids were there with us.  My daughter already lives in NYC and my son flew in from Dublin just for the occasion.  And as luck would have it, my brother and wife were in town from Aruba, so we got an extra dose of Timmers.  As we get older, life becomes more and more about making memories, and this was a memory worth making.   Plus, it was my first time eating Turkey Wellington!

If the time spent traveling is any indication of the state of the US economy, I can attest that the economy is just fine.  The drives to and from NYC were very long, and the traffic to Logan airport this afternoon (to drop off my son) was the most insane I have ever seen.  Everybody was leaving town, it seemed.  Pro-tip: avoid the departure lane and drop your passenger off at arrivals.  It saved us at least half an hour sitting in traffic (and possibly a missed flight).

Happy 26 Month Anniversary

After a newsworthy November, the cyclical bull market for equities is now 26 months old, producing a 73% return for the S&P 500, a 51% return for the equal-weighted index, a 48% return for the Russell 2000, and a 63% return for the MSCI All-Country World index.  The median bull market (S&P 500 index cap-weighted)

over the past 100 years has produced a 90% gain over 30 months.

Getting Younger

This has been an unusual bull market in some ways.  Aside from valuations, this cycle seems to be getting more youthful as it matures.  Most bull markets start broad and end narrow, but this one started narrow and is getting broader.  In its first year (2023), only 26% of stocks in the S&P 500 outperformed the index, but as of November 2024 that number has risen to 41% (the average is 50%).  It’s not a huge improvement but at least the tape is heading in the right direction.

A Strong Tape

Looking at a monthly chart of the equal-weighted index below, there isn’t much not to like.  The trend is firmly higher and 77% of the stocks in the index are above their 200-day moving average.  Technically, this market is on solid footing despite the concentration of the Mag 7.

The Soldiers Have Arrived

Even the long neglected Russell 2000 index finally notched a new all-time high last Friday (barely).  As I wrote back in January when the S&P 500 cap-weighted index finally made a new all-time high (but without the equal-weight or Russell 2000), the generals were leading but history shows that the soldiers do eventually follow.  Historically when the index has made a new all-time high after a bear market, momentum has usually followed and the following 12-month return has tended to be robust. That has certainly proven to be the case  thus far in 2024.

Animal spirits have been moving to the more speculative side of the market as well, pushing non-profitable growth stocks further above their 2022 lows.  They are a very long way from making all-time highs, but the last two years could be interpreted as a base.

One of my favorite indices, the S&P 500 low vol high dividend index (SP5LVHD), is now in all-time territory, while sporting a healthy dividend yield of 4.23%.  I continue to view this space as fertile ground if the market ever rotates away from the mega growers.

Sentiment

Despite the animal spirits in the price action, sentiment does not appear overly frothy.  The 12-month net flow into equity mutual funds and ETFs is a mere $115 billion despite the 73% gain.  That’s modest against a market cap of $50-plus trillion.

And the American Association of Individual Investors (AAII) survey shows slightly more bears than bulls.

And while I continue to be of the view that the ”$7 trillion mountain of cash” is not money sitting on the equity sidelines (it came out of the banks and not the stock market), it is true that there is more cash sitting in money market funds (MMFs) than would be explained by risk appetites (via the high yield credit spread, in orange below).  That suggests that more than $1 trillion of the $7 trillion could find its way into equities rather than returning to the banks (where it would earn 0.5%).

Valuation

While breadth has gotten stronger, valuations are becoming harder to ignore.  Below we see that the cost of capital for equities (with the earnings yield as proxy) has returned to the 2021 pre-bear market lows, even though interest rates remain much higher.

The S&P 500 now trades at 22.5x forward earnings, placing it at the edge of its historical range.  Valuations are poor predictors of short and medium-term returns, but these multiples don’t leave much room for error.  The operating margin notched a new cycle high last month (13.4%), so that remains a tailwind.

Earnings Amplifier

One way to look at market returns is to deconstruct them into their three parts: dividends, earnings growth, and changes in valuation.  Here we see how different the US market has been from other parts of the world.  Below we see that over the past 12 months, dividends contributed 1% of the return, earnings 8%, and changes in the P/E-multiple 22%.  A decent earnings gain has been greatly amplified by a significant multiple expansion.

Contrast the above with emerging markets, which produced the same 8% earnings, 3% from dividends, but only 1% from multiple expansion.

There are a number of reasons for that dispersion, including differing payout ratios (EM companies have tended to dilute shareholders, while US companies have tended to buy back way more shares than they issue), and of course the concentration of the Mag 7, which only the US has.  Below we see that while the equal-weighted S&P 500 continues to look OK at 19.8x trailing earnings, the cap-weighted index is approaching the 2021 “mini-bubble” extremes.

Follows the Earnings

Can the market repeat the double-barreled gains of earnings growth and multiple expansion in 2025?  I have my doubts.  With the term premium on the rise and the Fed possibly cutting less than the market expects (if at all), I think it will be difficult for multiples to expand much further from here.  That means that earnings will have to do the heavy lifting.  Fortunately, they are expected to do just that.

Calendar year 2024 earnings are on track to grow 10%, and the cal2025 estimate is holding steady at a 12% growth rate.  The chart below shows that the progression of EPS estimates has been relatively flat, which means they are resisting the usual downward drift.

However, that steadiness in the EPS estimates appears to be a function of the Mag 7.  If we show the same data but for the equal-weighted index, we get the chart below.  Now we see that the estimates are following the usual downward drift.  That’s normal and not a bad thing, but it highlights the difference in earnings momentum between the cap-weighted and equal-weighted index.

Still, the 2025 estimate of $427 is 13% above the 2024 estimate, and the 2026 estimate is 11% above the 2025 estimate.  That’s similar to the cap-weighted index, where the expected 2025 and 2026 growth rates are 12% and 12%, respectively.  So, this does show some broadness in earnings.

Now, compare the above to the MSCI EAFE index.  There has been downside momentum in recent weeks, and the 2025 and 2026 growth rates are only 6% and 8%, respectively.

The MSCI EM index shows even weaker momentum, although the growth numbers are better at 15% and 13%, respectively.  I’m not sure if this is all due to the stronger dollar (the EPS numbers are reported in USD), the threat of tariffs, or a little of both.

Wow

Price follows earnings, and relative price follows relative earnings.  Valuations matter, but they are unlikely to be a catalyst in the absence of a change in fundamentals. This has helped me resist the temptation to play the mean reversion game in the global equity markets.  But it’s possible that valuations can get so stretched that it doesn’t take much of a shift in earnings revisions to start the mean reversion.  In that regard, the latest monthly datapoint in the chart below gives me pause.

The P/E premium between the MSCI US index and ACWI ex-US index jumped markedly in November (now at 68%), with the relative return vastly outpacing relative earnings.  I know better than to call a top, but this chart got my attention.

The Fed

The PCE report last week produced an uptick in the core-PCE index, which is now rising at 2.80% year-over-year (up from 2.65% in October).  Following a similarly sticky CPI report, this inflation report confirms that the “last mile” on the road back to 2% is a tough one.  Three may indeed be the new two.  If neutral is inflation plus 100 bps, then the Fed may only have room to ease to 4%.

Whether the Fed cuts in December remains to be seen, with the market putting the odds of another 25 bps rate cut at 66%.  Various interpretations of the Taylor Rule suggest that the Fed is currently right where it should be at 4.50-4.75%, and clearly the economy is doing just fine.

In my view, the Fed could and should pause now or after the next 25 bps cut, to gauge if the animal spirits in the stock market are indeed a precursor to a re-accelerating economy next year.  If the Fed has not quite slayed the inflation dragon yet and the economy starts growing faster, the risk is that we get another wave of inflation in 2025.  That’s what happened during the 1966-1968 soft landing pivot and it could happen again.

Triangulating

For now, the 10-year yield has stabilized within its descending wedge pattern, and that has brought some calm to both the bond market and the dollar.  I do expect that 2025 will bring the occasional flareup in the term premium, which could interrupt (but not end) the bullish momentum in equities.

The dollar has also stabilized after ramping higher from the bottom of a long range to the top.  Perhaps the Red Wave trade is already peaking here.

It’s now December and we are in the historically most seasonally bullish period (November-April).  The momentum is there, and it’s not just the Mag 7.  There is lots to like about this bull market, and as Peter Lynch always said, you want to cut your weeds and let your flowers grow (or something like that).  The flowers are growing, but they are getting more expensive.  It has been a bullish broadening since October 2023, and that’s definitely something to give thanks for!

 

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.

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