by Jurrien Timmer, Director of Global Macro, Fidelity Investments
From playa decompression to P/E compression
As has been the case for a few weeks now, the relative calm of the headline S&P 500 (SPX) masks quite a bit of turbulence underneath. The index is only 1% below its most recent all-time high as earnings continue to boom and margins continue to rise (and credit spreads remain well-behaved). Yet less than half the stocks in the S&P 500 are trading above their 200-day moving average and only 27% are above their 50-day MA. Thank you, Mag 7, for keeping the index up, because otherwise the chart would look a bit different right now. With the SPX negatively correlated to oil and positively correlated to bonds, it’s easy to see why rates and oil prices are driving the bus right now. It’s a balancing act between rates and earnings, with an eye on 2022 as a possible analog for what lies ahead. Let’s explore.
The daily chart below shows how much mojo the market has lost in just a few weeks. The cap-weighted SPX has been in a trading range for 4 months now while the internals are churning. Suffice it say that the equal-weighted S&P 500 (SPW) doesn’t look good at the moment.
The Mag 7 are doing the heavy lifting right now. Perhaps they are deemed the best survivors in what may become a 2022 repeat wherein the weaker companies fall prey to a rising rates while the stronger ones are deemed immune. The Mag 7 has outperformed the equal-weight S&P 500 index by 18 percentage points over the past 13 weeks.
Market observers are pointing out that the internet bubble ended with narrow breadth and the market’s current internals need to be watched as a possible repeat. Indeed, the 1999-2000 blow-off top was an extremely narrow affair with only 20% of stocks participating at the end (below left). Fortunately, today’s 49% breadth (right) provides a favorable comparison for what is otherwise a scary price analog. Note that the two red arrows below are the exact same in both time and price.
Earnings are still booming, which is good news considering that investors are no longer willing to pay high multiples for those earnings. I think it’s a combination of peak earnings growth and rising rates (per the Fed model)
Beyond the Mag 7, the semis are strengthening as well, with the S&P 500 semiconductor group making an advance on its June high while speculators continue to retreat.
Semiconductor earnings continue to explode higher with the year-over-year change now at 178%. That almost perfect 40-month earnings cycle is looming, however. Perhaps things will be different this time in terms of their cyclicality, but those are words that always need to be chosen carefully!
A lot of the action remains on the rate side, with the 10-year yield reaching 5.25% on Friday and the real yield rising to 2.82%. Most concerning in the chart below is the real rate spike above the economy’s speed limit (potential real GDP). Hopefully that speed limit will increase as the AI productivity miracle arrives at some point. If not, rates have reached the point at which the mountain of debt might get deemed unsustainable.
What happens to equities if yields continue to rise? The simple answer is that per the DCF model the present value of future cashflows will decline, all else being equal. Fortunately, all else is not equal and earnings are booming. That means that the stock market can withstand a P/E derating without causing a bear market. Remember that in 2022 the P/E ratio fell 33% while earnings only grew 8% (and were decelerating from the post-COVID recovery). The result was a 28% bear market entirely driven by contracting multiples. I fear that a milder repeat could lie ahead if this bond bear market continues. Again, as long as earnings keep growing at double digits, the damage to price could be modest. For instance, per the Fed model below (which compares equity valuation to bond valuation), if the 10-year yield rises to 6%, that suggests an equity P/E ratio of 16x. It is currently 19-20x. A 4-point drop in the P/E ratio is a 20% valuation haircut, but if it’s offset by 30% earnings growth, we could be spared the kind of drawdown we experienced in 2022. Maybe a 2022 echo or aftershock.
Another visual for this dynamic is the investment clock below. On the horizontal axis are financial conditions and on the vertical axis I show earnings growth. We have been spending a lot of time in the very bullish upper left quadrant (easy financial conditions and accelerating earnings growth), but it looks like we may be heading into the upper right quadrant from here, which is less favorable. Note how we are in a similar position today as we were at the end of 2021 and the middle of 2018. We all know what happened next.
60/20/20
With the old 60/40 paradigm further in the rearview mirror of what used to work, the 60/20/20 has ruled the roost since the world changed after COVID, and I don’t see any reasons for that to change. Below is my updated back-of-the-envelope asset allocation. It’s not optimized (and certainly not investment advice), but I think it’s a good start.
The chart below shows 52-week Sharpe Ratios for the components in the 60/20/20. The insert shows my current weights for the model.
Beyond the 60 (global equities) and the 20 (bonds) the main diversifiers (against both asset classes) are commodities, gold, Bitcoin, cash, alts (equity L/S, managed futures, absolute return) and leveraged loans. Note how the equity bucket is to the right of center and the bond bucket is north of center. They are positively correlated to each other, which is what happens when the risk-free rate is competitive against risk assets and the Fed model becomes a dominant driver of equity valuations.
I continue to like both gold and Bitcoin, but especially Bitcoin looks interesting right now. For one we broke through resistance at $80k, targeting $100k.
Second, Bitcoin priced in gold (below) is showing a lot of strength as well as flows return to the BTC ecosystem. Bitcoin is only 30% correlated to the S&P 500 and uncorrelated to Treasuries. That makes it a good diversifier now that a new 4-year cycle is potentially underway.
Are TIPS better than nominals?
An important question is what to put in the bond bucket in the 60/20/20. Nominals or TIPS? I have been struggling with the question of whether TIPS are better than nominal bonds in this rising rate regime. They have been so far this year, but not by much (-1.7% vs -2.3% for the Agg). I have been exploring the relative value question for some time and only managed to confuse myself with the myriads of variables to consider. Are they real assets or bonds, or both? When do they behave like bonds and when do the behave like real assets? Are they driven by real yields or by break-evens? We see from the scatterplot below that the direction of travel for nominal and real yields is correlated (0.89 R-squared), but it’s not clear from the chart when and why TIPS might outperform (the size of the dots).
It’s also not evident to me that the TIPS break-evens are useful at forecasting inflation. The scatterplot below (showing the 5-year TIPS break-even against the realized forward 5-year CPI) suggests as much. Are the break-evens the collective inflation view of the market or merely a residual between nominal and real yields? I am increasingly of the view that there is little signal (which makes me wonder why the Fed uses this so much).
TIPS or nominals? With apologies to my fixed income colleagues for assessing this important asset class in such a rudimentary and primitive way (and ignoring what I am sure are a myriad of nuances), my conclusion is as follows. TIPS will outperform nominals (if held to maturity) if the realized forward CPI exceeds the current break-even, and vice versa. Duh. Can it really be that simple? Probably not, but bear with me.
Here’s my math. The chart below shows (top panel) the 5-year CAGR for the Bloomberg 7-10y Treasury index and the Bloomberg TIPS index, as well as the 5-year excess return (blue bars). I use 5 years instead of a shorter timeframe to approximate a hold-to-maturity timeframe, which for bonds is important. We see that the 5yr excess return CAGR peaked at 5.0% in early 2025 and has decelerated to 1.8% currently. Clearly the post-COVID rate cycle favored TIPS over nominals because the break-even in 2020 was far below the realized inflation that followed.
The next chart moves from 5-year trailing returns to 5-year forward returns. The forward excess return cuts off in September 2021, five years ago. The blue bars in the top panel show the realized forward CAGR of the BBG TIPS index relative to the BBG 7-10y index, and the black line is my estimate of what that excess return should have been (and could be in the future) using my back-of-the-envelope approach. The difference between the black and pink lines is the impact from the future inflation rate (4.0% vs 2.5%).
My rudimentary approach is to compare the break-even back then (2.53%) to the nominal (0.96%) and the real (-0.89%) and add in what we now know was a 5-year forward CPI CAGR of 4.0%. Assuming we hold-to-maturity, we know the TIPS real return was -0.89% and therefore the nominal return should in theory have been 4.0% higher at 3.1%. The actual forward return of the BBG TIPS index in September 2021 was only 0.53%, so clearly I am missing important aspects here (including the difference in duration and yield of the TIPS index vs straight 5-year TIPS).
We also know that the 5-year nominal Treasury’s nominal forward return in September 2021 should have been 0.96% (if held to maturity), which suggests that the real return should have been 4.0% lower or -3.06%. The realized 5yr CAGR was -1.25%, with again important nuances being ignored (especially the differences between the duration of the BBG 7-10y index and the 5yr note). My objective here is to get the direction of travel right for the relative return of TIPS vs nominals, and based on the decent fit between the black line and the blue bars, I think I got that.
My conclusion? Today, at a 5-year break-even of 2.35%, a real 5-year yield of 2.62%, and a nominal 5-year yield of 5.0%, the choice is to buy the nominal Treasuries at attractive yields but run the risk that inflation is more than 2.35% over the next five years. Or, I can buy 5yr TIPS and lock in that juicy 2.62% real yield but without knowing whether the realized inflation component will be big enough to compete with nominals. Based on my simple exercise and my expectation that the old 2% inflation regime is past and that the 3-4% regime of the last 5 years is here to stay, my clear choice is TIPS with their compelling real yield and (too) low breakeven.
Which is not to say that TIPS will generate a positive return over the next 5 years. But they should outperform nominals if inflation stays elevated, and no worse than nominals if inflation reverts to 2.5%.
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