by Denise Chisholm, Director of Quantitative Market Strategy, Fidelity Investments
When investors ask about risk, the instinct is often to catalog the unknowns and then forecast how each might hit markets. We get the impulse - but history hasn’t been especially kind to that approach. Markets have a long track record of advancing through bad news, something we’ve written about repeatedly. The uncomfortable truth about “unknowns” is that they are always with us. Each episode feels unique, but the constant is uncertainty itself. That’s why we prefer to start from a different place: not the risks we can’t yet see, but the quantitative signals embedded in market prices today. Rather than guessing what might go wrong, we ask a simpler question - what is the market already discounting, and what does that imply for risk‑reward?
That brings us to what we’ve observed over the past six months. We’ve seen a rapid, double‑digit contraction in equity multiples - an unusually large and fast move. Historically, declines of this magnitude are rare, occurring less than 5% of the time. The last two comparable episodes were 2022, when earnings did fall, and the financial crisis. Multiple compression is the pure math of discounting: prices adjusting to account for worsening assumptions.
When we examine outcomes following these bottom‑5% multiple contractions, the pattern is decidedly asymmetric. Forward returns form a U‑shaped distribution, and while multiple expansion isn’t inherently negative, unusually large contractions have tended to set the stage for strong advances. On average, markets have gained roughly 15% over the subsequent year following moves like the one we’ve just experienced.
The natural counterpoint is that both prior examples were accompanied by genuine fundamental deterioration. Earnings declined. So far, that’s not what we see today. Much like during last year’s tariff tantrum, earnings growth has remained resilient, even in the face of higher oil prices - a dynamic we’ve discussed in prior notes.
Historically, when multiples aggressively contract but earnings growth remains positive, the market advances over the following year roughly 95% of the time. And even if earnings ultimately do weaken - if we get that call wrong - the market has still advanced about 85% of the time. That’s the positive risk‑reward in numbers. None of these odds are certainties, but they illustrate how much bad news is already reflected in prices. If earnings hold up, the probabilities skew heavily toward upside. If they don’t, history suggests much of that downside has already been discounted. It’s the same conclusion the data has been pointing to all year: the market is pricing in far more risk than most investors realize.
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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