by Jurrien Timmer, Director of Global Macro, Fidelity Investments
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.
Follow or Fade?
We are now almost two weeks post-election, and with the House now also called for the Republicans, this truly has been a decisive red wave. I will leave the societal implications to others to ponder, and will as usual focus on the markets.
Per the chart below, the standout winner of this red wave has so far been bitcoin, which soared past $90k last week. Follow or fade? I will have an update on this later on in this report.
Bullish Broadening
As for equities, aside from the wobble last Friday on reduced expectations from the Fed, the bullish broadening has continued, with both the top 10 and bottom 490 stocks making new all-time highs. It’s good to see, and preferable to what a disorderly broadening might look like (in which the Mag 7 sells off and takes the cap-weighted index down with it).
While both the equal-weighted and cap-weighted S&P 500 remain in well-defined uptrends, the Russell 2000 index remains just below the previous all-time high set in late 2021, and remains in a downtrend vs the S&P 500. The broader market is participating in this bull market, but it’s not (yet) leading.
Dollar Hegemony
Part of the red wave has been a soaring dollar, in part because a presumed new capital formation cycle amid ongoing fiscal expansion is likely to bring with it higher term premia and fewer (if any) Fed rate cuts. The chart below shows that the dollar index has roundtripped from its range lows to range highs in very short order, while expectations of further rate cuts have been paired back (measured as the difference between the 12th Fed Funds futures contract minus the near-term contract). Follow or fade?
Fully Valued
In terms of volatility and valuation, it’s hard to see things improve very much from here. The implied equity risk premium (iERP) sits at 320 bps (the same as in 2021), while high yield credit spreads are down to 256 bps. Follow or fade?
Dufecta
The stock market in 2024 has rallied strongly on a combination of growing earnings and expanding P/E-multiples. The same thing happened in 2017, which was the first calendar year of Trump 45. Then in 2018 earnings continued to grow but valuations started to compress (as is typical). With the trailing P/E already at 26x and up 29% year-over-year, is it realistic to expect a repeat in 2025? I don’t think so. It’s not difficult to see earnings continue to grow in 2025, but in my view, they will have to do most if not all the heavy lifting. Perhaps 2025 will be more like 2018?
2017 vs. 2024
Below we can see the historical ebbs and flows of earnings vs valuations, going back 150 years. The correlation has been generally negative, for the simple reason that price discounts earnings growth by several quarters. Therefore, price (and by extension the P/E-multiple) is usually zigging while earning growth is zagging. The exceptions to this rule are the soft landing Goldilocks cycles, such as the mid-1990’s and mid-2010’s.
In the chart above I show earnings growth on the horizontal axis and the change in the P/E-multiple on the vertical. The blue line shows that the current cycle started in the typical way (valuations higher and earnings growth lower), but is now producing simultaneous earnings growth and P/E-expansion. The Greenspan era was very similar (pink line), as was the first year of Trump 45 in 2017 (red). The green line shows what happened after 2018 and 2019 (earnings higher, valuations lower).
Earnings
I suspect 2025 could be a repeat of 2018, with earnings doing all the heavy lifting. So far, the earnings trend remains good. While the rate of change in forward estimates seems to have peaked (based on falling 2025 estimates), Q3 earnings season was another winner, with the growth rate bouncing to 9%.
Below we see the same pattern but in dollar estimates. Q3 has produced a solid $2.8/share bounce.
For 2024, the growth rate has been on track all year at 9-10%, but the 2025 estimate is coming down a touch, as is typical.
Liquidity
With the potential for a new deregulation-induced capital formation cycle amid ongoing fiscal expansion and some degree of Fed easing, the theme for 2025 seems to be “ample liquidity.” The global money supply is growing again, and the 2-year TIPS real rate has narrowed from +2.8% to +1.75%.
The Fed
To what degree the Fed will slow down its rate normalization cycle is unclear at this point, although Fed Chair Jay Powell hinted on Friday that it may slow down the pace of rate cuts. All my versions of the Taylor Rule show that the Fed’s target rate has caught up to the improvements in both the labor market and the rate of inflation, and that it can afford to slow down the pace as we await what the red wave brings next year.
Bonds
For long bonds, the big question is whether the long-dormant term premium will finally revert to normal (i.e., positive, as risk premia should be) during a red wave. Absent a rising term premium, the fair value of the 10-year yield could just track the Fed’s forward curve and the trend in GDP growth. Per my bond model below, 4% would be fair value if the Fed cuts rates a few more times.
But if we use that same model to also solve for a return to 150 bps for the term premium, we get a higher fair value. I can easily imagine a cycle in which occasional rate tantrums to 5% or above slow down the stock market’s momentum. These tantrums don’t have to end the bull market, but they could surely interrupt it.
Three is the New Two
Part of the rising term premium thesis is a move towards fiscal dominance, and the inflation that this could produce. If so, bonds will likely continue to be positively correlated to equities, as they have been since 2022 and as they were from the mid 1960’s through late 1990’s.
The Secular Bull Market
A rising term premium and above-target inflation seem like a plausible next chapter for a maturing secular bull market which by my count is now 15 years old. The last two (1949-1968 and 1982-2000) lasted 18-19 years, which puts the current super-cycle at the 7th inning or so.
Interestingly, the 10-year compound annual growth rate (CAGR) peaked in 2019, exactly in line with the previous two waves. If history repeats (and acknowledging the tiny sample size), the next ten years will be less robust (but still positive) than the last ten, and we could be switching from above-trend returns to below-trend returns around 2028.
Regime Change?
What all this means for the Mag 7 and the rest of the market remains to be seen. Per the chart below, a mean reversion of the mega growth dominance seems plausible at some point, from the perspective of both the duration and magnitude of the current wave. Timing a 10-year relative CAGR has its challenges, and we are still missing a catalyst (in the form of relative earnings). My guess is that a secular rotation out of US mega caps and into everything else (value, small caps, ex-US, commodities) will be part of a regime change from secular bull to secular bear.
An Update on Bitcoin
With Bitcoin busting out of its six months long range and now on a possible approach to $100k, let’s re-assess the bullish thesis that I have held since 2020.
Rhythmic Cycles
Bitcoin appears to be following the playbook of the last two winters-turned-into-summers. There’s an unmistakable rhythm to Bitcoin’s cycles.
Alien Asset
Bitcoin is in a world of its own, as illustrated by the drawdowns and rallies of all asset classes.
A Viable Aspiring Asset that Should at Least be on the Menu
Despite its boom-bust cycles and high volatility, Bitcoin remains quite competitive in terms of its 5-year Sharpe Ratio and limited correlation to the S&P 500.
The Network
My main focus for the valuation of Bitcoin has been the shape of the demand (adoption) curve. Since its inception, Bitcoin’s price has been closely linked to the size and growth of its network, with the occasional over and under-shoots that are to be expected from an emerging asset going through price discovery.
With the emergence of ETPs, not to mention direct brokerage accounts on exchanges, it’s not clear to what degree the count of addresses and wallets is being understated by the publicly available on-chain data. In the chart above, I simplistically added 5% to the address count to adjust for the fact that Bitcoin ETFs/ETPs account for 5% of the overall market value. It’s almost surely not correct, but I wanted to just see how much it would move the needle (not much).
The OGs are HODLing
Below we see the distribution of wallets by the value they hold. It’s remarkable how committed the OGs have been, despite three harsh winters and massive profits. If they don’t sell when prices are low or when prices are high, when will they? Wallets holding $10 million or more account for over half of all wallets. Now that’s dedication!
Demand Curves
About four years ago when I first went down the Bitcoin rabbit hole, I developed several demand models based on historical S-curves, as well as a supply model based on a modified version of Plan B’s S2F model. They are shown below.
I developed these models as a guide to help me understand this unique asset, and my conclusion was that while the supply is known, the demand is not. The slope of the adoption curve determines the size of the network, which per Metcalfe’s Law determines the value. Even the slightest change in slope can have a profound impact on valuation, given that we are dealing with exponential math.
Of all the S-curves that are historically available, I settled on mobile phones and internet adoption as the most relevant. The latter is shown below. As you can see, we are at the point where that curve’s exponential slope is becoming less exponential (more asymptotic). By this measure, Bitcoin is maturing.
Based on that S-curve, I built a regression model that added a layer of monetary policy outcomes (from -2% real rates to +2.5% real rates). The chart below shows this hypothetical valuation framework. Again, this is not meant as a price prediction, but as a guide to understanding Bitcoin’s use case as a network asset that also has monetary features.
Power Law
While Bitcoin’s network growth (measured as wallets with a non-zero balance) has slowed down significantly this year, it remains in line with the power curve shown below. Again, it’s very likely that the wallet/address count is understated given that ETPs only use a few wallets.
The slope of the power curve is steeper than the slope of the internet S-curve. I ran a similar regression with the inclusion of not only real rates but also money supply growth, and the chart below shows a comparison of the two hypothetical paths.
Again, these are not predictions, but merely attempts at visualizing the use case on the basis of adoption, real rates, and monetary inflation (with the latter two undoubtedly affecting the former).
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