by Jurrien Timmer, Director of Global Macro for Fidelity Management & Research Company
And just like that, the stock market rocketed to new highs last week after facing a 10% price decline and 19% valuation drawdown only two weeks earlier. The speed is breathtaking but on par with corrections in secular bull markets. The 20% decline in the fourth quarter of 2018 and the 21% decline exactly one year ago produced similar V-shaped recoveries. Now the question is whether the market has gotten ahead of itself in declaring victory? My hunch is yes. Let’s explore.
Heatmap
The heat map below shows that the forward P/E is still 9.5% below its high, which is encouraging. Thank you, earnings, for doing the heavy lifting in keeping this market correction in check. Breadth is decent, with the number of stocks trading above their 50 and 200-day moving averages ending the week at 61% and 62%, respectively. Stocks and bonds remain positively correlated to each other, as are gold and bonds, as are the dollar and Bitcoin. Needless to say, stocks and crude oil remain negatively correlated.
Technicals
The rally off the March 30 low has been fairly uniform, although the cap-weighted S&P 500 has gained more ground (to new highs) than the equal-weighted index as the Mag 7 rocketed back to life after a six month correction.
The Mag 7 has now fully roundtripped back to the October all-time highs, pulling the cap-weighted index with it.
The AI boom certainly helped take the market to new highs, as attention refocused from the Strait of Hormuz back to the technological marvels at home.
Bear flag or base?
Bitcoin continued to build up last week, making a new recovery high of $78,344. The rally off the $60,033 low could still be described as a bear flag (not unlike the bear market rally last fall), but my sense is that Bitcoin continues to build a large base here in preparation for the next major up wave.
Sentiment
The equity melt-up of the past two weeks was surely driven (in part) by short covering. The call/put ratio below has now surged from 1.02 to 1.50.
Yields & the Dollar
The cease fire in the Middle East helped keep the bond market calm and the dollar from surpassing resistance at 100-101. The fact that the dollar’s gains were less than impressive suggests that the next major move is down.
Oil shocks: 1990 vs 2022
With crude oil prices driving equities right now, let’s take a look at two examples of oil shocks. The 1990 Gulf War took oil prices from $41 to $100 (in today’s dollars) was short-lived and caused only a brief 19% drawdown in the P/E ratio. Clearly the markets today are pricing in a similar outcome, and now that the rebound is complete, we will need to see the narrative continue for the gains to be justified.
In 2022 during the post-COVID inflation spike, oil prices rose from $79 to $136 (again in today’s dollars). That oil shock lasted longer and partly as a result, so did the correction in equities. There was more going on of course, including a massive Fed cycle and a generational reset in bond yields.
My conclusion is that the longer oil prices remain elevated, the more protracted the recent correction will get.
Earnings
Earnings season begins this week and the consensus estimate is for a 13% growth rate (year-over-year). That estimate will likely go much higher as companies begin reporting. The “incoming waves” of future quarters are all trending up instead of the usual down.
The calendar year estimate for 2026 has now risen to 18%. Generally the progression is downward, except for years when earnings are recovering from a contraction. One exception was 2018, when earnings were booming from the TCJA tax cuts in 2017. Keep 2018 in mind as I will revisit that year later.
Corrections during earnings bull markets
As I have discussed in recent weeks, the resilience and even acceleration in earnings has kept the recent decline to single digits instead of the nearly 20% drawdown in the forward P/E ratio.
The chart below shows the various noteworthy episodes when earnings are growing 15-20% year over year while the P/E ratio was in a drawdown of 15-20%.
The next chart shows the bell curve distribution for the 12-month earnings growth rate (dark blue) and the 3-month change in the P/E ratio (light blue). The data set is weekly going back to the 1950’s. Note how earnings and valuations are on opposite ends of their distributions.
How often has it happened that the P/E multiple falls 10-20% while earnings are growing 10-20%? A few times, actually. As the table shows, notable occurrences were 1973, 1987, 1994, 2000, 2018, and 2022. As Denise mentioned in her excellent note last week, more often than not the forward 12-month return is positive (seven out of 10 times according to my calculations).
However, there have been some noticeable misses as well. The May 1973 signal produced another 19% decline over the following 12 months, and the May 2000 signal produced another 21%. The February 2022 signal produced another 18% drawdown. All three signals occurred during the early innings of cyclical bear markets.
Happier examples include the May 2010 signal, which was a mid-cycle correction 14 months after the GFC bottom, and 2018. That year started with “Volmageddon” (when inverse-VIX ETFs blew up) and ended with a rate tantrum when the Fed pushed rate normalization too far.
The 2018 analog
Earlier I mentioned 2018 as an interesting comparison year, and here’s why. That was the year when earnings were booming as a result of the TCJA in 2017, but this did not prevent a 10% correction in late January and another 20% decline in Q4. It’s something to keep in mind as we ponder how much support the robust earnings backdrop can lend to a market that needs to absorb a lot of headlines.
60/20/20 to the rescue
With bonds and stocks once again positively correlated (per the chart below), the current/recent market episode served as another reminder to look beyond the 60/40 for that balance between returns and risk.
Since 2022 I have been exploring a 60/20/20 model as the “new” 60/40. Why? Because the correlation is positive and because problems can just as easily occur on the 40 side as the 60. The remaining 20 centers on uncorrelated diversifiers, such as managed futures, commodities, gold, cash, and yes Bitcoin.
Scattered plot
Especially commodities have done their job recently, generating alpha while becoming more and more uncorrelated against both stocks and bonds.
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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