by Jurrien Timmer, Director of Global Macro for Fidelity Management & Research Company
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.
Lurching from Confidence to Doubt
Markets continue to price in a possible left tail, and the S&P 500 remains at the -10% correction threshold. With the first quarter all but over, it has certainly been a whirlwind these past few months.
As the old adage goes, markets don’t like uncertainty, and the change in narrative from last November’s animal spirits playbook to a now much more uncertain future has been palpable. More uncertainty means higher risk premia, which is what we are getting.
We have had several quick non-recession drawdowns of 20% over the years, including the LTCM (Long-Term Capital Management) crisis in 1998, the Eurozone debt crisis in 2011, and the growth scare in 2018. They were sharp but swift, and needless to say they were great buying opportunities. Market cycles that are priced for recessions that don’t happen are the ones we want to rebalance into.
But if the combination of fiscal austerity and a potential trade war bring us that recession that we were all expecting in 2023, then we are likely not done correcting. That’s especially true if the Fed Put is now further out of the money with the core-PCE inflation rate remaining stubbornly close to 3%.
But how do we know in real time? We don’t, unfortunately. But we can look at the tape, sentiment, valuation, earnings estimates, and credit. What these clues tell me is that while the market is moderately oversold and sentiment is cautious, it’s not priced for a recession. That suggests that further patience is warranted here.
What are investors to do? Fortunately, there have been places to hide this year, from international equities to Treasuries to gold. This is why we diversify! For me, the big question is whether the rotation out of the Mag 7 is a bump along the road to continued AI and mega cap dominance, or the BIG one.
If the former, this too shall pass, and probably quickly. But if a new secular regime is afoot, the game going forward will be all about the alpha instead of the beta, since it will be very difficult for US equities indices to gain ground when its biggest constituents are declining. We will want to cast a wide net in terms of what assets to own, while lowering expectations of what equities can deliver.
Anatomy of a Correction
We all know the math: the stock market has historically grown by 10-11% over the long term but only gone up 60-70% of the time. That means it has corrected 30-40% of the time. Surviving those drawdowns is the price of admission.
The odds of being in a 10% drawdown have been around 40% for the S&P 500. This appears to be one of those times. The chart below shows all drawdowns of at least 10% going back to 1900.
After 10%, What’s Next?
Is there any historical pattern that a 10% correction is buyable? Without some contextual assumptions, the short answer is no, other than relying on the odds that the market goes up more than it goes down. But that’s cold comfort when your portfolio just declined 10% in only a few weeks.
The chart below shows what happened after the S&P 500 corrected 10% in the past. If you see a clear pattern here, please let me know! It’s a hot mess of wide dispersions.
It’s interesting how closely we are following the 1998 cycle (light blue line). That was the LTCM non-recession bear that resulted from a repricing of the so-called convergence trade (when levered investors bought spread product while shorting Treasuries). A totally different dynamic than today, except that both cycles were catalyzed by an unwinding of crowded trades.
Un-pricing for Perfection
As I wrote back in November, the setup following the election was reminiscent of 2021, when the markets reached bubbly territory as the helicopter money was raining down. The VIX was low, as were credit spreads and the implied equity risk premium (iERP). It wasn’t wrong per sé, but everything had to go right (which it didn’t when the inflation genie was released).
This time around, the market was again priced for perfection, with investors betting on pro-growth laissez faire policies while hoping that the tariff stuff was just a means to an end. But investors are now rethinking that assumption. Remember: when valuations are high, the margin for error is low, and vice versa.
Bracing for a Slowdown
Evidence is growing that investors are pricing in an economic slowdown. Sentiment is cautious, earnings estimates are moderating, credit spreads are widening (slightly), yields are down, the dollar is weakening on widening rate differentials, and GDP forecasts are coming down. Per the chart below, the Q1 2025 GDP estimate has declined from 2.2% to 1.3% in only a few weeks. But that’s still a slowdown, not a recession.
Meanwhile, the S&P 500 total return index (top panel) is back on its 2007-2024 trendline, which is consistent with a slowdown. If we get a recession instead, the pendulum will likely swing all the way to below the trendline, suggesting another 10% of downside risk.
What Does Credit Know, or Doesn’t Know?
We often look to the bond market for clues when it comes to equity risk. Credit analysts focus on balance sheets, and they often sense trouble before the equity folks do. Today, there is a sense in the market that credit spreads are not confirming the correction in equities (i.e., they are not widening). That suggests that this is merely a “non-recession correction” and not something worse. What can history teach us?
Using the same 10% equity correction study I showed earlier, the chart below shows the change in investment grade credit spreads during equity drawdowns. Spreads have widened only 20 bps so far, and from a historically very low starting point (110 bps last month).
The next chart shows equity drawdowns and spread changes over a longer timeframe (using weekly data). For this current cycle, the S&P 500 is down 10% from its 2-year high and IG spreads are up 20 bps from their 2-year low. That’s more or less what happened during last summer’s 10% growth scare (and yen carry trade unwind), and that correction was a nothing burger.
The chart shows that almost all equity drawdowns are accompanied by spread widening. That makes sense since equities and credit are both risk assets and therefore should be somewhat correlated.
Looking at this another way, below we see the equity drawdown vs spread “drawdown” in a scatter plot.
The current correction is still in the “nothing to see here” part of the chart. That suggests to me that there is no signal yet from credit that we need to worry that this equity correction will turn into a recessionary bear market. That could change, of course, which is why credit is such an important indicator to watch.
What Comes Around…
Moving on to the equity fundamentals, what I suspected would happen in 2025 is indeed happening. That is, after two years of P/E-expansion, multiples are contracting and are offsetting what is otherwise a decent earnings cycle. We all knew that last year would be hard to repeat, with 12% earnings growth amplified by multiple expansion. Right now, trailing earnings are up 10% year-over-year while the P/E is down 3%.
Valuations
Looking at valuation in particular, the forward P/E ratio has come down 2.5 points, which is good. At the same time, the implied ERP has gone from 3.2% to 3.7%. That’s better than before but still well below the historical average of 5%. Based on the long-term average EPS growth rate of 6% and an iERP of 5%, the fair value P/E multiple is around 17x. We are still 3 points above that.
Are Earnings at Risk?
We know that times of uncertainty bring downside pressure for multiples, and that’s especially true when those multiples are in the top decile. That brings us to the “E” in the P/E. With Q1 earnings season about two weeks away, it’s worth considering how the current economic worries are affecting earnings estimates.
So far, the damage seems to be limited. Per the chart below, the year-over-year growth rate for Q1 EPS continues to follow the typical pattern of progressing downwards to the long-term average of 6-7%. I don’t see many signs of an abrupt erosion, but we still have a few weeks before earnings season begins.
Mag 7
However, the estimates for the recently highflying Mag 7 have not progressed much in recent months. That could be a tell that the best days are behind us for this cohort. The Mag 7 is trading at 30x trailing earnings and 27x forward earnings. That’s a lot better than just a month ago when the group was trading at 42x trailing EPS, but the combination of stalling earnings growth and lofty valuations is probably not a good one.
Quarterly Squiggles
Looking at the S&P 500 estimates quarter by quarter, it’s hard to gauge whether the downward drift in Q1 estimates is the usual pattern of estimates starting too high and then coming down to earth, or something more cyclical. It will be important to track to what degree Q1 earnings season produces the typical bounce that happens in most quarters.
Garden Variety Rotation, or the Big One?
For me, the existential question is not so much whether we go into a recession. We have seen that movie before, and as long as an economic contraction is not accompanied by a debt bubble or liquidity crisis, this too shall pass.
But the market is so top heavy that if we are starting a secular rotation out of the Mag 7 into everything else (especially non-US equities), it is likely to have deeper repercussions than whether the economy is growing or not.
We don’t know whether the current rotation is the big one or just another blip on the radar, but as the chart shows below, the risk/return landscape is so lopsided towards the mega growers that it can become a systemic event for the markets. There’s a lot of catching up to do if the Mag 7 reverts to the ACWI ex-US.
Alpha vs Beta
For investors, that means that we may have to rely on the alpha rather than the beta. The chart below shows that the MSCI ACWI ex-US index has languished below its 2021 all-time high for four years now. It has been dead money in absolute terms (beta) and a disaster in terms of relative performance (alpha).
But relative to the Mag 7 (which is back at its lows and down 20%), that flat beta doesn’t look so terrible.
Maybe a flat beta is all we are going to get for a while, as markets, sectors, and regions all play musical chairs as investors ponder who the winners and losers are going to be in this disruptive and pivotal moment in history.
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