by Jurrien Timmer, Director of Global Macro at Fidelity Investments
Secular Subtleties
It was another relentlessly bullish week, as hopes for a resolution in the Strait of Hormuz pulled Brent down to $91/barrel and took the 10-year yield back into its triangle after reaching 4.69%. AI stocks led the charts as usual, with participation from the more speculative side of the market spectrum (below). With commodities down on the week, TIPS break-evens retreated back to the mid-2’s. This market continues to be in a tug-of-war between two sharp tails, with an earnings-driven AI boom (possibly turning to bubble?) on the right, and higher inflation and a tighter Fed triggering the Fed model lurking on the left. In between is a cyclical bull market that has turned 45 months old, producing a 118% return (based on the S&P 500). At the same time, the secular bull market is ongoing, and whether it will eventually end with a valuation bang or an inflation bust is the topic of discussion in this week’s WAAR.
Cyclical Bull
The cyclical bull market that started on October 13, 2022, has now turned 45 months, well past the median age of 30 months.
The 118% return places this cyclical bull in the top 4 of strongest bulls since 1960. It remains quite narrow in terms of breadth, making for an interesting comparison to the 169% bull market from October 1998 to March 2000.
Earnings Driven Bull
This bull market started slowly in terms of earnings, but boy have they caught up. Based on current estimates, earnings will likely continue to play a large role in shaping this cycle.
Margin Expansion
And those earnings are supported by margin expansion, which are a powerful driver for valuation. While the S&P 500 index is in the upper reaches of its valuation band, the 22x forward P/E ratio is supported by both margins and credit spreads.
Secular Subtleties
Let’s explore the secular bull market, when and how it began, and when and how it might end. Secular bull markets are “super cycles” spanning up to two decades during which returns are well above average. They are interspersed by secular bear markets, which tend to last a decade or more and produce below-average or even negative returns. The chart below shows that the yellow secular trendline (since 2009) is much steeper than the pink “central” trendline (since 1871). We are now above both of these trendlines as the secular bull gets further and further along its track.
How Old is the Secular Bull?
The consensus among many technicians is that the current secular bull market started in 2013 when the S&P 500 index finally surpassed its 2007 high after a lost decade. I am in the minority with my thesis that the bull started in 2009 at the end of the GFC. For me, the 2013 milestone was the confirmation that a secular bull was underway, but in my view, it started four years earlier.
Why 2009? Because that’s when a number of important factors lined up. The chart below illustrates that from the perspective of trend deviation (against the 150-year central trendline) as well as the 10-year CAGR, the inflection points for the four secular bull markets of the past 100 years are 1921, 1949, 1982, and 2009.
Those starting points are further confirmed by valuation via the 5-year CAPE ratio, as shown below. By that measure, the P/E bottoms that line up with the above are also 1921, 1949, 1982, and 2009.
CAPE Model
The technical considerations above are also supported by the CAPE model. The chart below shows the CAPE model based on the 5-year price-to-payout ratio (which measures dividends and buybacks as the denominator instead of earnings). As you can see, the 1949-1968 and 1982-2000 secular bull markets line up nicely with the post-2009 super cycle as well as the CAPE model. And that model suggests that returns over the next ten years will be less robust than the last ten. That’s the blue trendline in the upper panel.
Measuring secular trends is more of an art than a science, and the sample size is tiny. There is no right or wrong way to do this in my view, but the above two charts suggest to me that 2009 was the start of the current super cycle. That suggests that we are in the later innings of this super-cycle. I am more than happy to be proven wrong, but given that the last two secular bull markets lasted 18 years, then it’s worth asking the question of how and when this one will end.
What drives the bull?
To answer the question of what might end this ride, we first need to ascertain what is driving it. The following few charts offer my take. First, clearly mega cap growth stocks are a feature of the outsized returns. The 50 largest stocks in the S&P 500 index now comprise 60% of the market with seemingly no end in sight.
Earnings and especially margins have been a powerful driver, pushing valuations higher in lock step.
Capital flows have also been a driver of the “US exceptionalism” theme of the past decade. The Tariff Tantrum a year ago did nothing to stop that train.
And of course, financial engineering has been a powerful force. When we add up the new supply of shares (via IPOs and secondaries) we get $3.5 trillion in new supply in the S&P 500 since 2009. Now when we add up the demand for shares via M&A and buybacks, we get close to $30 trillion. That’s an almost 10:1 ratio of demand vs supply. No wonder the market is up 17% per annum since 2009.
Fewer Buybacks?
Now come to subtleties. While buybacks are still a dominant feature of the financial engineering landscape, we can see below that the capex boom is forcing down buybacks and dividends, at least as a percentage of earnings. It’s a minor nuance (I think), but it might be a sign that the financial engineering bonanza is cresting.
Here is a look at the supply and demand over time. Remember that there are two sides to this equation, with the demand for shares overwhelming the supply of shares.
Inflation Bust?
A boom-turned-bubble is one scenario for an end to the secular trend, but an inflation bust is another. Below we see that commodities appear to have entered another secular bull market of their own. What’s interesting about this is that super-cycles for commodities and equities tend to be mirror images of each other (illustrated by the 10-year CAGRs below). So perhaps the strength in commodities is a subtle early warning sign for the secular trend in equities.
If commodities continue to rally, the “open jaw” below between the Bloomberg Commodity Spot Index and the 5-year TIPS break-even will be a challenge for the bond bulls. One of those lines is wrong, I think, and if it’s the inflation break-evens, then it has implications for the Fed and therefore for bonds and therefore for equities via the Fed model.
The Fed model returned to relevance in 2022 after being dormant for several decades. The Fed model simply holds that if the risk-free asset is competitively priced against the risk asset (equities), and its valuation derates, then so must equities. Hence, per the above chart, if inflation remains sticky in the 3-4% area and pushes up the TIPS breaks, then bond yields may well rise into that danger zone of 5% or above, which per the Fed model could force the stock market to derate.
Valuation is the Key
Secular bull markets always end with a valuation reversal, either because they reach bubble levels unsupported by fundamentals (1929 and 2000) or because they get derated by inflation (1968). Whenever the current trend comes to an end (hopefully not anytime soon), it will likely be for one of those two reasons. Perhaps it will even be both, if the two tail risks manifest at the same time. But for now, valuations are supported by the fundamentals of margins and credit spreads, so let’s enjoy the ride while we can.
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 expr
1265487.2.0
Copyright © Fidelity Investments
