by Jurrien Timmer, Director, Head of Global Macro, Fidelity Investments
Key takeaways
- Earnings estimates for the third quarter put the earnings per share (EPS) growth rate in Q3 at 28%, compared to 54% in Q1 and 96% in Q2.
- Earnings growth seems to have peaked for this cycle, and forward valuations are coming down as well. This is a typical transition in the cycle, which suggests that the rapid ascent of stock prices slows from here.
- The business cycle has transitioned to mid-cycle phase with some signs of late cycle. This can sometimes produce a "wobble," which indeed has happened in recent weeks.
Earnings season is here, and it may turn out to be a pivotal one. After several quarters of huge beats, it's possible that the growth rate for the third quarter will be less stellar (but still positive). After gains of 54% in Q1 and 96% in Q2, the expected growth rate for Q3 EPS is 28%.
While earnings growth may yet surprise to the upside, I doubt it will be by the 30 percentage points of the last 2 quarters.
Here is what we know:
First, history shows that price follows earnings, except for at the tails. Very negative earnings growth tends to produce positive returns, because this usually occurs at market bottoms, while very positive earnings growth does not seem to be correlated. In other words, investors don't reward extremely high earnings growth because it tends to be unsustainable. The same thing happened in 2018 following the Tax Cuts and Jobs Act of 2017.
Second, the growth rate of earnings estimates has clearly peaked for this cycle. This isn't a bad thing per se, but it does mean that growth will likely moderate from here. This is a classic transition from early cycle to mid-cycle.
Third, valuations are now coming down. The forward price-to-earnings ratio (P/E) has already compressed by 3 points (from 23x to 20x), and more is likely on the way.
This combination of developments is typical for this stage of the cycle (mid-cycle). The chart below shows that there's typically a clear sequence around early-cycle recoveries. Earnings growth is in yellow and P/E growth in light blue. The yellow bars extend into 2022 because they include current estimates.
Here is the sequence: First, the market bottoms, then earnings typically bottom a few quarters later. In between those 2 inflection points is a big expansion in the P/E multiple. From there, the P/E ratio peaks on a rate-of-change basis, then earnings growth goes positive, then the change in the P/E ratio turns negative, and then earnings growth peaks.
What typically follows this sequence is a period of slower (but still positive) earnings growth, combined with multiple compression. Multiple compression is what happens when a company's earnings are up but the stock price stays the same or falls. As a result, the market loses its steep upward slope as the bull market transitions from its early-cycle V-shape to a more trend-line mid-cycle phase.
But with this transition comes the occasional wobble. You can see in the chart above that this happened in 2010 as well as 2004. But these are just corrections in a cyclical bull market.
And of course, seasonally we are right in the zone for such a wobble. The S&P 500 has corrected 5% so far, and the seasonal window typically starts to improve from here. So perhaps we have already seen the worst of it. Either way, based on the above sequence the advance from here should be decidedly less robust than the last 18 months.
One big question for the market is whether the leadership will change back to value, now that rates are back on the move. We know that the long duration growth stocks are quite convex to interest rates, and that the relative performance of cyclicals/value stocks (especially financials and energy) is positively correlated to rising yields. Duration refers to how sensitive a company's cash flow is to changes in interest rates. Long duration stocks are more convex which means they are more sensitive to changes in interest rates than value stocks.
So, in theory, if bond yields rise to a new equilibrium (I'm guessing 2% for the 10-year vs. 1.6% as of October 20), then value should take over.
I doubt that the employment report from October 8 will dissuade the Fed from starting its taper soon, so that suggests that in 2022 the bond market could be facing the opposite supply/demand dynamic as in 2021. In 2021, the Treasury issued less paper (because it was running down its cash balance at the Fed), while the Fed continued to buy $120 billion per month. Next year it could be the opposite as the next 2 rounds of fiscal spending get funded right as the Fed tapers down to zero.
So more supply and less demand for Treasurys should push prices down and yields up. That could be a plus for value stocks while softening returns on some growth investments. As always, it makes sense to make sure your investments are diversified in order to potentially benefit from swings in either direction.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
