by Jurrien Timmer, Director of Global Macro, Fidelity Management and Research
Play the middle but mind the tails
With earnings season wrapping up, investors continue to weigh what is on the one hand a promising and powerful AI narrative and a friendly Fed and well-behaved bond market, against what is on the other hand a low risk premium, top-heavy concentration, mediocre breadth, some emerging froth, and sky high projections for how much this AI boom will cost while knowing little about the ROI that it will bring.
It leaves a narrow path forward, bound on the one side by the right tail of an equity boom possibly becoming a bubble, and on the other side by a left tail of a benign interest rate environment potentially turning more hostile. In the middle is a bull market now in its fourth year, driven by earnings growth and capex.
Overall, it may be a pretty good setup for harvesting beta, but it’s important to have a plan in place to navigate those tails should one or both of them occur. Given the state of play for this ever-so-2025 market cycle, I wouldn’t be surprised to see both tails happen at once, or in rapid succession.
Robust earnings
For now, the markets are basking in the glow of a strong earning season. What started as a projected 7% growth rate for Q3 earnings is now a 15% growth rate. A 700 bps bounce is well above average, and is a continuation of the strong results produced during the last three quarters.
The strong quarter has lifted the calendar year estimate to +11.5%, which is almost where the year started, and above where 2024 ended. It’s rare to see earnings estimates accelerate during the year, unless we are coming out of a recession.
Earnings go global
And the news looks good oversees as well. The forward estimates for non-US markets are accelerating and are now closing in on the US. This is reflected by the performance of the MSCI ACWI ex-US index, which is now beating the MSCI US index by 800 bps on a year-over-year basis. That’s the highest since 2017.
How much is too much?
The question on everyone’s mind is whether this market has gotten over its skis betting that the AI boom will lift the economy’s non-inflationary speed limit and, in the process, enabling the US to outgrow an increasingly problematic debt burden.
I did a back-of-the-envelope exercise using the discounted cash flow model (DCF) to estimate at what combination of earnings growth and equity risk premium (ERP) the current level of the S&P 500 may be justified. Looking at the Bloomberg earnings estimates for the next few years and assuming a trend-like growth rate of 7% thereafter, the projected 5-year compound growth rate (CAGR) for earnings is 11%.
Given that 11% projection, the current level for the S&P 500 index only makes sense at an implied equity risk premium (iERP) of 3.7%. That’s what the DCF model solves for: it assumes the price is correct, and then using variables like earnings growth, the payout ratio, and the risk-free rate, it spits out a “required return.” From that return we subtract the 10-year yield and we get the iERP. The current iERP of 3.7% is not the lowest ever but as the chart shows below it's well below the long-term average of 5%.
We can use the DCF to solve for earnings growth as well, by holding the ERP constant. If the ERP was currently at its historical average of 5.0% instead of 3.7%, and we take that 11% EPS expected growth rate and plug it into the DCF model, the S&P 500 fair value drops to roughly 5,000. Ouch.
Putting this another way, at the current price level of 6730 and a “normal” ERP of 5.0%, we would need to see earnings grow by 18% per year for the next 5 years to justify the market’s current price level. It’s not impossible if the AI boom is the game changer that many expect it will be, but it’s not a small feat either.
Anyway, this kind of DCF exercise is a good way to assess what the market needs to believe for current levels to make sense. Currently it seems to believe that earnings will substantially surprise to the upside. The market is priced for success.
Not like 2000 (yet)
With all the talk of bubbles, we can’t help but connect the dots to the internet bubble of the late 1990’s. I have been highlighting the price analog for many weeks now, concluding that we are not yet in “silly season.” The next few charts support this notion as well.
Below we see that from the 1998 LTCM low to the 2000 peak, the trailing P/E on the Nifty Fifty (50 largest companies) rose from 20x to 40x while the bottom 450 languished at 20x. The chart shows that the 50 largest stocks “cannibalized” the rest of the market until the bubble imploded on itself, as all bubbles do. Valuations seem better this time around, with the top 50 stocks trading at a 29x trailing P/E while the rest of the market trades at 24x.
Bollinger Bands
Technically, the late 1990’s was much more extreme than anything we have seen thus far. The chart below shows “detrended Bollinger Bands,” which is technical geek speak for how many standard deviations the S&P 500 is above or below its underlying trend. Back in the late 1990’s the market was consistently more than two standard deviations above its trend (often even 3, 4, or 5), whereas today it’s 1.7 standard deviations above trend.
Retail is buying
The late 1990’s also produced ebullient sentiment, as one would expect during a bubble. I would characterize today’s sentiment backdrop as “enthusiastic” but not much more than that.
Insiders are selling
What is catching my eye is that while sentiment is leaning bullish among retail investors and Wall Streeters, corporate insiders are selling at the highest level since 2000. The chart below shows the Vicker’s Insider Sell/Buy index. Typically, this index only produces meaningful signals at market lows when CEOs and the like buy their company stocks at depressed levels. They have all kinds of reasons to sell shares, including for compensation, so there is usually little signal there. That may well be the case today, but given the conversation about valuation and bubbles and loft earnings goals, the current 25:1 sell/buy ratio is something that gives me pause.
Mind the tails
Where do all these mixed signals leave us? We are in a market cycle where investors seem to be lurching from one tail to the next. A boom is the right tail, but a bubble would eventually take us back to the left. A rising term premium on long bonds would also be a clear left tail, but that side is dormant for now.
At a yield of 4%, the 10-year yield offers limited value in my view. While bonds are not as positively correlated to equities as they were in 2022, they are no longer negatively correlated either. We can see this in the scatter plot below, which shows the 5 year correlation of the asset classes I track against long term Treasuries (horizontal) and the S&P 500 (vertical).
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 Investments
