by Jurrien Timmer, Director of Global Macro for Fidelity Management & Research Company
Another week, another major news event. While we wait for the news flow to unfold from the Middle East, there is so much we do not know, and whatever we do think we know is subject to change at a moment’s notice. So, I will keep things short this week and focus on what the charts are saying and what anchors we as investors can drop to shore up our portfolios.
What do we know? The cyclical bull market is now 41 months old and is starting to flatten out as the mega cap growers lose their leadership. It makes sense that a bull market in its fourth year starts to churn, and that what is happening.
Global markets are at or near all-time highs, supported by strong earnings growth around the world. The rest of the world is outperforming the US on a combination of better earnings growth, competitive payout ratios, and lower valuations.
As such, the valuation premium of the US over international equities continues to erode, with the premium falling from its peak of 68% to 41%. Price follows earnings, and we can see from the top panel that a major inflection point is in place on both counts.
For the US, the S&P 500 index is well above its trendline as it has gained 103% since the October 20222 low. Earnings have been driving the bus (up 13% yoy), while valuations have taken a back seat (up 2%).
Those earnings come at a cost, at least for the cap-weighted S&P 500, in the form of upper percentile valuations. But beneath the surface of a top heavy index, valuations are fairly reasonable with the S&P 500 equal-weighted index trading at a 19x trailing P/E.
At the same time, the equal-weighted price index remains in a solid uptrend and unlike its cap-weighted sibling is not over its skis from a trend perspective. The broader market is well-grounded from a price, breadth, earnings, and valuation perspective.
It’s the cap-weighted market that I worry about. Concentration risk is a real thing, and with the Mag7 appearing to barely holding on to a now four-month long trading range, I suspect won’t take much for this cohort to enter a Bonafide correction.
Should it do so, we may get our first 10+% correction since the Tariff Tantrum of last spring.
Beta vs alpha
Corrections come and go, and if all we get is a 10-15% drawdown while the fundamentals remain robust, then it will just be a simple matter of rebalancing. Still, a balanced portfolio should have diversifiers, especially in word in which the tail risks on both sides are fat. Bonds have been the traditional diversifier and did that job well until the rate reset in 2022. Since that time, the correlation has started to fall again, and as the chart below shows, on a 52-week bass bonds are once again negatively correlated.
Even before the news over the weekend, the 10-year yield dropped below 4%. I don’t see much value there, but what do I know? Maybe bonds are sensing trouble, or they foresee a major deflationary wave from the AI revolution.
With the core-PCE at 3% and the forward curve pricing in a 3% terminal rate for this easing cycle, that means unless inflation falls from here the Fed will presumably cut real rates to zero at a time when R-Star is 1.5% and the economy is booming. Seems like a tall order, but again, perhaps this dovish outcome reflects an AI-driven deflation.
Another way to diversify to help fend off concentration risk and the possibility of a diminishing beta is to go down cap within the US and overseas. The timing seems to be right for this because the correlation between the equal-weighted and cap-weighted S&P 500 has come down to only 46% while the correlation between the S&P 500 and MSCI ACWI ex-US has flipped negative. It’s pretty remarkable that we can stay in the 60 bucket while truly diversifying.
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
