by Jurrien Timmer, Director of Global Macro, Fidelity Management & Research Company
Rebalancing Act
The news flow continues to come in fast and furious, but underneath the headlines the market has continued to calmly evolve and rebalance to a healthier and less concentrated leadership. Maximizing the signal-to-noise ratio continues to be one of the more important disciplines during this market cycle to help stay on the right side of the trend and to avoid the whipsaws. Amid all the headlines about Greenland, renewed tariffs, and the Fed, let’s see what the charts say.
Right tail recovery
Since that short-lived but scary 21% drawdown back in early April, the S&P 500 has surged ahead faster than any other period in history with the exception of the LTCM drawdown in 1998.
Bullish broadening
At least for now, the US stock market is rebalancing in one of the best ways possible. The mega caps seem to be taking a rest while the rest of the market breaks out. For now, the broadening is not a zero sum game.
Market breadth
With the Mag 7 now stuck in a range since November, the broader market has gone from narrow to broad, from 32% of stocks trading above their 50-day moving average to now 73%.
A boom instead of a bubble
The S&P 500 has continued to follow the 1998-2000 price analog, but without the excesses. Breadth appears much better today, and the mega growth leadership has been trading at a fraction of the valuations that were experienced in 1999. That’s hardly a bubble, which suggests that the current cycle could eventually part ways with the analog below.
Balance
The following chart shows relative momentum curves for the various parts of the stock market. Here again we see balance being restored. Unlike a few months ago when there was a lot of talk about AI bubbles, today there are fewer outliers. Of all the pockets in the market, commodity-sensitive equities show the most momentum.
Sentiment
Sentiment-wise, while investor flows have been strong, there is nothing here that indicates to me that sentiment levels are overly frothy. Put/call ratios and the various sentiment surveys are not at extremes.
Earnings & Valuation
Earnings growth continues to expand on a year-over-year basis, but is peaking on a 5-year basis. Over the past 12 months, EPS growth has contributed 12 percentage points of the market’s return, while multiple expansion has contributed 2%. That’s a far cry from the earlier days of this bull market cycle when P/E-multiples dominated.
Investment clock
If we look at the investment clock (earnings growth on the horizontal vs financial conditions on the vertical), we see that the market has moved clockwise from 2 o’clock to roughly 10 o’clock. The previous cycle (blue line) produced a much bigger rotation (to the midnight hour!), but that came on the heels of a big COVID-driven earnings decline and subsequent recovery. Either way, positive earnings growth combined with supportive financial conditions is a good quadrant to be in, and one that we will want to be on the right side of.
Valuation
What about those expensive valuations? Yes, they are lofty at 25.3x and the market will be over its skies if earnings growth decelerates meaningfully from here. Per the DCF heatmap below, at the currently estimated growth rate of 14% (per Bloomberg estimates), the S&P 500 index is reasonably priced with an implied equity risk premium (iERP) of 4.5%. That’s below the long-term average of 5% but not by much. The grid shows (in blue) where the intersection is between earnings growth and valuation. For example, if EPS growth falls to 9%, the iERP falls to 3.6%, and if it accelerates to 17%, the iERP climbs to 5.0%.
Peaking cycle?
Per the earnings growth cycle study I shared last week, it looks like the current earnings cycle is peaking at a 5-year CAGR of 14%. Per the BBG estimates, the 5-year growth rate is expected to fall from 14% currently to 9% in a few years. That suggests valuations are likely also at peak levels.
Earnings season
Q4 earnings season is underway, but with only 31 companies reporting so far, it’s too early to tell if we will get the same impressive bounce as we did in Q3 and earlier. My guess is that we will.
Global earnings
Either way, to me the real story is the acceleration in global earnings. The year-over-year growth rate in EAFE and EM earnings has been accelerating much faster than the US (which as indicated above is reaching peak-cycle conditions). Since earnings drive price, the excess return of ex-US equities has been accelerating accordingly.
In fact, non-US equities have been so strong that they have displaced gold on the periodic table (which shows 3-month rolling returns).
Relative valuation
If we line up the major regions of the world according to their expected earnings growth and WACC (weighted average cost of capital)[SG1] , we get the following scatter plot. Using the DCF formula we solve for the required return (WACC) that justifies the current price at the expected earnings growth rate. It shows that the US is trading at 25.3 times earnings with a consensus earnings growth estimate of 13% (for the next three years). EAFE is trading at 17.2x and an expected 8.5% earnings growth rate, and EM is trading at 15.7x an expected 14.5% growth rate. To me, EAFE presents the biggest opportunity given how modest the EPS estimates (and P/E) are compared to the US.
Relative performance
The MSCI EAFE index is now outperforming both the S&P 500 cap-weighted and equal-weighted index, and is doing so with strong breadth.
And EAFE continues to show good price momentum relative to the US.
Monetary policy
Meanwhile, the Fed remains in the crosshairs of the US Administration, while the market awaits the outcome of the selection process for the next Fed Chair. With the exception of the Bank of Japan, all major central banks are in easing mode. In my view, this limits the controversy over the Fed getting “flipped” by the White House, at least for now. My sense is that any tinkering at the Fed by the next Chair and his supporters will be less visible in terms of the Funds rate and more focused on coordination with the Treasury (in terms of debt management and bank regulation).
The FOMC will meet again soon but there is little expectation that another rate cut is in the works. The Fed Funds rate is now smack in the middle of the dot plot and only 5/8 points from what the Fed considers a long-term neutral rate (and 3/8 from the terminal rate in the SOFR curve). Another rebalancing act.
The dollar
With fewer rate cuts on the immediate horizon, the dollar has continued to go nowhere fast. I am still surprised how quiet both the US Dollar Index (DXY) and the 10 year Treasury yield have been since the tariff turmoil 10 months ago.
Inflation
One thing that is catching my eye is the rapid deceleration in the Truflation index. It’s a noisy series and one that I’m not going hang my hat on too much, but the year-over-year rate is now down to 1.72%, while the Truflation core index yoy change has fallen to 1.60%. Something to keep an eye on as we ponder the downstream dividends from the AI boom.
Asset allocation
My 60/20/20 model index has continued to benefit from its allocation to gold, commodities, alts, and bitcoin. The latter has been mired in a correction but is starting to show some signs of life. You can see that in the Shape Ratios below.
Gold & Bitcoin
Gold has continued to perform extremely well amid this evolving global world order. It also has been keeping up with the ever-expanding global money supply, which now sits at $116.5 trillion and growing at an 11.4% annual rate.
And Bitcoin? It’s hard to know whether the correction is over and the uptrend is resuming, or whether the rally from $80k to $95k is a countertrend bounce. Futures open interest has dropped substantially, as have ETF/ETP flows.
But Bitcoin’s momentum curve has been a huge outlier. Perhaps some rebalancing is in order here as well.
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
