by Jurrien Timmer, Director of Global Macro for Fidelity Management & Research Company
The weather in Reno this weekend (where my campmates and I are doing our annual spring cleaning for Burning Man) is a good reminder of how quickly things can go from sunshine to rain, and then from darkness to rainbows. I took the above photo across from the construction yard where our containers are stored and can confirm that it is 100% natural and unfiltered.
The last few months have certainly been a rollercoaster of emotions, from the “what, me worry?” animal spirit days back in February to the fear of a deglobalized and de-dollarized capital war in March, to a now more sanguine vibe that the more moderate voices are being heard .
With a few months of price action now under our belt, we have a better sense of where the pressure points lie within both the equity and bond markets. Very sharp upward moves in yields have gotten the attention of the White House, as have very sharp declines in equities. That gives us a bit of a sense that the circuit breakers have been found.
Technicals
With last week’s continued recovery in stock prices, the S&P 500 index has now overtaken the “line in the sand” at 5500. That was the former breakdown point which tends to serve as the line of first resistance on a rebound. Now that this line has been taken out, a deeper retracement or even a retest of the old highs becomes the playbook.
From 1998 to 2018
With the 1998 analog no longer “in charge,” the 2018 analog has taken over in terms of which past correction looks the most like the current one. That 2018 bear-scare produced a sharp 20% drawdown, which was quickly reversed when Fed Chair Powell pivoted from his hawkish stance. From there, the market went straight up. I don’t see the same thing happening this time, but while we don’t have a Fed put for this cycle, we do seem to have found the Trump put. The effects are the same.
Cyclical Context
Whether the cyclical bull market ended in February of this year, following a 30-month 76% advance, remains to be seen. If this was just a bear-scare like 2018, one could argue that the bull market remains alive and will soon be confirmed by new highs. Until that confirmation arrives, however, this could just be nothing more than a sharp retracement rally.
An Average Bull?
If the cyclical bull did end in February, it will go down as being average, judging by both its length and magnitude. As the chart shows, a 76% advance over 30 months is consistent with many past bull markets. The concentration within the market has been anything but average of course.
Long or Short?
At times of uncertainty, I find it useful to pull up a simple chart of the S&P 500 and ask myself: do I want to be long or short this chart? Different people will come up with different answers, but for me the chart below suggests “long.” We have a rising uptrend line and a market that just swung from well-above it to well-below. We are now at that line, which suggests that the market has found its balance.
Earnings
Yes, earnings estimates are falling as the market is getting repriced to one of slower (but positive) growth, but those lowered earnings estimates are now commanding lower P/E multiples. We can see below that while Q1 earnings season has been very good (with the year-over-year growth rate jumping 560 bps so far), the estimates for Q2, Q3 and Q4 have all been marked down by 300-400 bps.
Valuation
Those lowered estimates are now commanding lowered P/E multiples. The 5-year cyclically adjusted P/E ratio (CAPE) fell from a nosebleed 32.9x to a more reasonable 24.9x and has since rebounded to around 28x.
The Fed
As for the Fed, it is rightly on hold as it awaits more clarity from both the growth and inflation side of the spectrum. The Fed has a dual mandate of full employment and 2% price stability, and right now it is stuck in between both ends. The good news is that recent inflation prints have come in soft, pushing the inflation rate a bit closer to the Fed’s target. As the chart below shows, the Fed is really just following the 2-year inflation rate to wherever it’s going, and right now it’s going down.
Taylor Rule
We can see this progress from different flavors of the Taylor Rule, which provide a rules-based approach to monetary policy. After being stuck in a holding pattern for most of last year, all iterations are now falling again, supporting the notion that the Fed has more room to cut rates.
Beware Stagflation
The Fed is on hold because it is justifiably concerned that a trade war would cause growth to slow and prices to rise. No one likes stagflation, including the Fed. With the market’s worst fears being played down, perhaps we won’t cross that Rubicon, but it’s interesting to note that the Purchasing Manager’s Index (PMI) is already squarely in the stagflation zone.
Bonds
As for bonds, they remain in that 4-5% range, where they have been for some time now. The long-term chart still looks more bearish than bullish to me, with the post 2022 action looking like a bear flag. That suggests that a yield above 5% is more likely than below 4%.
US vs Ex-US
The Tariff Tantrum of the past few months has produced a rapid repricing of US vs ex-US equities. That 68% P/E premium in February is now 50% as international earnings estimates are now outpacing US estimates.
Are Valuations Justified?
While the US continues to trade at a substantial premium, one could argue that this is justified based on superior historical earnings growth and higher payouts. That’s what the chart below shows. Were that to change, then the math will change with it.
Labor vs Capital
One very large question hanging over the markets is whether we are entering a new structural era in which the world deglobalizes and de-dollarizes, and in which the pendulum between labor and capital swings towards labor. I don’t have a good way to depict this pendulum, but the chart below makes an attempt. If a regime shift is afoot, then equity valuations are still too high. But this is a question without an answer for now.
1188536.16.0
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 Management & Research Company
