by Jurrien Timmer, Director of Global Macro for Fidelity Management & Research Company
Please note, this report was written on Sunday, April 6th. Given markets are moving fast, a mid-week Weekly Asset Allocation Review may be posted
And just like that, in a matter of weeks we went from post-election animal spirits to pricing in a slowdown to now bracing for a recession. The S&P 500 is down 17.5% from its all-time high, just shy of the bear market threshold.
Whether this becomes a bear market remains to be seen, and there have been several 20% drawdowns over the years which quickly recovered (think 1998, 2011 and 2018). This could well be one of them, but for now the knife is falling fast and we have not yet reached the kind of oversold extremes that in the past have created high conviction buy signals.
At the same time, the current rotation from the Mag 7 to the rest of the world is happening as the secular bull market has reached its twilight phase. That makes the stakes higher than usual, both in terms of the alpha and the beta. Is a tectonic shift taking place?
Technical indicators have now reached “medium” oversold conditions. We’re not quite there but we are getting close. Let’s review.
Are We There Yet?
OK let’s unpack this mess. The S&P 500 is down 18% from its high, and it has done so in short order. Declines of this magnitude happen every few years. The last one was in 2022 (-28%), the one before that was in 2020 (-35%) and the one before that in 2018 (-20%). So, this happens every few years, and the market has always recovered, often quickly and sometimes slowly.
Adding some irony to the situation is the fact that the market peaked right as the cyclical bull market turned 30 months old. That’s the median age for all cyclical bull markets going back a century. Given how highly dispersed those cycles are, having a bull market end right at median is uncommon and somewhat befitting of today’s “Stranger Things” zeitgeist.
Anatomy of a Drawdown
As the analog shows below, this drawdown has been fast and fierce. The best price analog for now is 1998.
In terms of the “what happens after a 10% drawdown?” question posited in last week’s report, the market has spoken as shown in the chart below. The good news is that we appear to be near the bottom of the range in terms of speed and magnitude when looking at historical outcomes. That suggests that the market could perhaps find some balance in the weeks ahead.
How Oversold?
How oversold is the market? Pretty oversold, but not epically so. The percentage of stocks above their 200-day moving average is down to 23%. That’s in line with the 10% drawdown in the fall of 2023, but well shy of the 2022 bear market lows (-28%), let alone March 2020 (-35%).
The percentage of stocks above their 50-day average is down to 13%. Again, that is on par with decent sized corrections but not bear market extremes (which have often produced low single digit readings).
Not an Extreme
Looking at the breadth data going back to 1927, we see that 29% of the S&P 500 index has now reached a 52-week low after last week’s selling. Again, that’s in line with other medium-sized corrections (2016, 2018, 1998), but well shy of the “close your eyes and buy” levels produced at generational extremes. The 35% COVID crash in 2020 produced one of those rare signals, and it proved to be a good one.
Trend Deviation
Revisiting the Bollinger Bands from last week, we have gone from 2 standard deviations above-trend to on-trend to now almost 2 standard deviations below-trend. Again, oversold but not at an historic extreme.
Growth Scares & Recessions
Now that the market has repriced from growth slowdown to something worse, the next question is whether that recession is coming and whether it will be a garden variety reset or something worse. We don’t have a bear market yet, but should we find ourselves in one, per the table below history tells us that the median non-recession bear market has been -22% (not far from where we are now), and the median recession bear market has been -35%.
Where’s the Leverage?
The difference between a “technical” recession and a financial crisis is often leverage combined with an asset-liability mismatch. On the surface, I don’t see many instances of excessive leverage the likes of which we experienced during the financial crisis. The Fed is not tightening and therefore not inverting the yield curve, the banks are well-capitalized, and there is no obvious consumer or corporate debt bubble that I can see.
The one area that some will probably point to are the private markets, namely private credit. That has been a vastly growing sector which often deploys leverage combined with illiquidity. The stock and bond prices of the big players in that space will be worth watching for signs of stress. Some of the stock prices are down 40% already. But I am no expert on private markets, so I will defer to others here.
LTCM
One example of a (brief) non-recession bear caused by a rapid deleveraging was the LTCM cycle in 1998. The chart below shows a near-perfect analog of today’s cycle and 1998.
Fundamentally, the two cycles couldn’t be more different, but they both revolved around an unwinding of crowded trades. Back then it was corporate and sovereign bonds (levered 50 to 1) and today it has been the Mag 7 and the momentum trade in general.
The Fed Put Remains Out of the Money
Chairman Powell spoke on Friday and rightly deferred on becoming more dovish. Inflation has not been tamed, and could get worse if we find ourselves in a trade war. Unless we are entering a deflationary recession, this lowers the strike price of the Fed put, and with it the downside potential for bond yields. The forward curve is now pricing in a 3% Fed Funds rate. I’m not sure how plausible that is in a stagflationary setting. Bonds are compelling at 5% but not so much at 4%.
Higher Lows
One of the things that I have worried about since the pandemic is that the rate of inflation never round-tripped far enough below the Fed’s 2% target to allow the longer term average to mean-revert back to 2%. The 5-year inflation rate is currently 4.4% and rising.
In a disturbing parallel to the late 1960’s, the COVID-induced inflation spike in 2022 mimics what happened during the late 1960’s (Guns & Butter). Like then, inflation hasn’t fallen enough to bring the 5-year average back to target. If we now get another inflation wave as a result of tariffs it would start from an elevated baseline, just like happened during the early 1970’s. That’s the stuff that could end not only the cyclical bull market but also the secular bull market.
Speaking of the late 1960’s, I have highlighted in the past the similarities between the 1966-1968 soft landing and 2022-2024 period. That analog remains uncomfortably close. The 1968 peak marked the end of that secular bull market. Will 2025 be the same? It’s not my base case, but I wouldn’t bet against it either. I will cover the secular context more next Sunday.
Earnings & Valuation
The price action has been too fast and furious to affect earnings estimates thus far, but that will likely change with earnings season starting this week. For now, earnings growth remains at 10% and is expected to grow another 9% this year. But if the declining GDP estimates are any guide, that number is likely to come down in the coming weeks.
The baton Has Been Passed
Valuations, which did the heavy lifting in 2023 and 2024, are now detracting from returns, as I suspected they would, with the P/E ratio now down 10% year-over-year. Starting points matter, and the current drawdown started from a high one in terms of valuation.
The juxtaposition of growing earnings and falling valuation is reminiscent of the 20% haircut in late 2018. That cycle recovered very quickly, thanks to a quick Fed pivot. But the Fed might be less inclined to pivot this time around, given the aforementioned inflation backdrop.
Back to Earth
Fortunately, valuations have greatly improved in recent weeks, and the trailing P/E ratio for the equal-weighted S&P 500 is back in the “normal” range, However, if earnings estimates start coming down, the forward P/E ratio may not improve much from here.
The forward P/E-multiple is now 18.3x, down 4.3 points from the peak and closer to my estimate of fair value of 17x. That’s based on the discounted cash flow model (DCF), assuming long-term earnings growth of 6% and an equity risk premium (ERP) at its historical average of 5.0%. Progress.
Credit Spreads
Are credit spreads confirming a recession scenario? Not yet, but they are heading in that direction. Investment grade spreads have widened by 40 bps but remain very modest by historical standards.
High yield spreads have widened out quite a bit, but at 468 bps are not too far from their historical mean.
And the scatterplot of equity drawdowns and spread changes still has us in the “garden variety” zone.
What’s Up with the Dollar?
One of the more unsettling features of the market’s sudden derating is the weakness in the US dollar. Just like that, the Dollar Index is approaching the range lows. What’s going on here?
Typically, or at least since the GFC in 2008, periods of market stress have led to rallies in the dollar. You can see that in the chart below, which shows the correlation between the USD and S&P 500 (green) and equity drawdowns (purple). As the drawdowns get worse, the correlation has often turned negative.
The US dollar is the world’s funding currency, so when the margin calls come in, the dollar usually goes bid. But in recent weeks a falling dollar has accompanied the drawdown in equities, and the 52-week correlation has flipped from -61% late last year to now +4%.
Could it be that the world is not only de-globalizing but also de-dollarizing? Is a new secular regime emerging, in which the dollar ceases to be the dominant reserve currency? We used to have the gold standard, and that was followed by the Bretton Woods regime, in which the dollar was tied to gold and other currencies were pegged to the dollar. When that ended, we got the “Bretton Woods II” era, in which the US sent their dollars abroad (to buy oil and consumer goods), which were then recycled into our Treasuries, equities, companies, and real estate.
Are we transitioning to another regime, in which Bretton Woods II is replaced by a more insular world where regional trading blocs replace the labor-arbitraged globalized system of the past few decades? That does seem to be part of the Administration’s goal, so perhaps we shouldn’t dismiss it too quickly. It would explain the price action in not only the dollar but also gold and even the Mag 7.
These are existential questions that could affect our investment approach for years to come. I will try to peel this onion in next week’s report.
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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