by Jurrien Timmer, Director of Global Macro at Fidelity Investments
How crowded is crowded?
We are on the cusp of second quarter earnings season, which begs the question as to whether estimates have now risen so much that they will be hard to beat. How the market responds when earning growth and estimate revisions peak after such a torrid run might give us an important clue about how crowded the space has become, and therefore how vulnerable it is to liquidations. With all the talk of the billions that ETFs in the tech/semi space have attracted, this is a timely question as we enter earnings season.
From my perspective, fast money shakeouts do not kill a bull market as long as the fundamentals support the trend, which they seem to be. Nevertheless, I continue to favor a barbell approach of owning AI/growth, but “hedged” with income-oriented equities from the “ex-AI” space (which stands to potentially benefit from AI adoption, perhaps while the hyperscalers reach the point of diminishing returns).
Meanwhile, with the Strait of Hormuz back in the headlines amid signs that the US economy continues to run hot, long rates around the globe (except for China) retested their cycle highs last week. The US nominal 10-year now stands at 4.56% and the real 10-year (TIPS) at 2.30%, leaving a paltry 2.26% for the implied expected inflation rate. It seems too little to me, which makes me favor the real over the nominal. But with TIPS being the mysterious creatures that they are, it’s never that easy. While I am not predicting that the 10-year yield shoots up to 5%, I do think it’s one of the market’s main tail risks (along with concentration risk).
Finally, the evolution in the supply/demand dynamic for US shares (IPOs vs buybacks) continues to raise my eyebrows, especially at year 17 of the secular bull and with an eye on the dot.com analog. It’s a subtle slow-moving train that is unlikely to give an actionable signal, but with the secular bull market advancing in age, we should be on the lookout for signs that the drivers of this bull are still driving.
Let’s explore.
The US equity market has continued to broaden nicely, with the S&P 500 equal-weighted index making consistent new highs while the cap-weighted index takes a breather.
Trailing and forward earnings growth has continued to accelerate higher, with valuations taking a back seat. At 21%, trailing EPS growth is now close to the 2018 peak, which followed the TCJA in 2017.
Of course, the main event this week will be earnings season. The growth estimate for Q2 is +23%, which seems like a high hurdle to beat. Last quarter the estimate started at 14% and doubled during reporting season, so we’ll see what happens. My guess is that companies will beat as usual, but maybe less so than in the past. Note the two orange lines below, which were the 2018 quarters that started high and beat by only a little.
With all the talk of semiconductor ETFs captivating the fast money, I can’t help but keep an eye on the dot.com analog. I’m sure this analog will break down at some point (as all analogs do), but so far it has continued to be spot on, both in terms of price and the 5-year CAPE ratio.
One big difference between now and then is that today’s fundamentals are backing up the valuations. While the 5-year CAPE ratio above raises eyebrows, booming earnings are so far keeping valuations in check. In fact, the chart below showing the forward P/E against high yield credit spreads suggests that valuations are quite reasonable today.
One question mark hanging over the secular trend concerns the supply and demand for shares. We know that there’s an issuance boom underway (second only to 2021), with more share dilution hitting the tape as early as next month when SPCX insiders get unlocked.
But that’s only half the story. The other half is that the current capex boom is taking away the bandwidth for companies to buy back their shares. Below we see that companies are increasing their debt issuance while they are issuing more shares. This comes at the expense of buybacks, which as a percentage of earnings is down to only 31%.
The buyback era that started during the mid-2000’s has been part and parcel of the secular bull market that started in 2009. But the share count has been rising since 2023, and now buybacks are falling as well. Is the de-equitization era over?
Overall, the supply/demand picture remains OK, with the sum of buybacks and M&A activity vastly outpacing IPOs and secondaries (at least on a 12-month basis). But it’s worth keeping an eye on this dynamic as we ponder the next (and final?) few innings of the secular trend.
Between concentration risk, AI froth, an evolving supply/demand picture, and possibly a rising cost of capital, how do we hedge our bets? Fortunately, there are ample opportunities both within equities and beyond.
Within equities, the market has remained separated between AI and ex-AI, seeming to make it a binary choice to either stay at the party or go home. One of the few outliers remains the Eurozone banks, which have delivered outstanding returns on par with the AI space while being largely uncorrelated to the S&P 500 index and sporting a P/E of only 11x.
The EZ banks may not be very interesting in terms of their earnings growth, but they have returned 88% of their earnings via buybacks and dividends. That equates to a cash yield of 7.2%, which is generous compared to the S&P 500.
Beyond European banks, the S&P 500 ex-AI remains a good place to look for uncorrelated returns. Below we see that the ex-AI basket is only 20% correlated to the S&P 500 (SPX) on a 50-day basis, much lower than the equal-weighted S&P 500 (SPW).
The other area of uncorrelated returns are Chinese equities, which at 10.7x forward earnings have lagged far behind the MSCI EM index.
China has been the sole outlier in the race for higher payouts.
Bonds: nominal vs real
The US 10-year yield re-entered the danger zone (4.5-5.0%) last week, driven entirely by real rates, which have now risen to 2.30%. Investors always face a choice between real and nominal bonds, with nominals often winning, but today I wonder if the paltry 2.26% break-even spread is enough compensation for inflation risk at a time when real rates are as generous as they tend to get.
As straightforward as that choice might seem, we are dealing with TIPS here, which can behave like real assets or bonds, or both. Below we see that at the current level of real yields (2.3% and nominal yields (4.56%), the forward relative return of TIPS vs LT Treasuries is usually not positive (as depicted by the “empty” circles below). Based on the chart, it seems like the best time to overweight TIPS is when both nominal and real yields are ultra-low. That is hardly the case right now.
Perhaps commodities remain the real asset of choice here, given that oil prices are now priced for success in the Middle East and given that the BCOM Spot index remains totally uncorrelated to both the S&P 500 index and the BBG LT Treasury index. TIPS on the other hand are positively correlated to both indices.
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