- Earnings seem to have peaked and rates moved higher, making the market math challenging.
- Trade and inflation have been impacting earnings while the Fed has been impacting bond markets.
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.
Since hitting new highs in September, the S&P 500 has fallen about 4%. Some people are worried that it's the beginning of the end for the bull market. But just because a bull market changes and stops going up, that doesn't mean a bear market has started. A market can sit and go nowhere for a while before moving up again.
Viewpoints caught up with Fidelity director of global macro Jurrien Timmer to get his take: He thinks that the market was complacent about rising interest rates and is reacting to slowing earnings, but rather than the start of a major decline, the market is likely in a trading range for 2018.
What has driven the recent sharp sell-off?
Timmer: It's really a continuation of what has been happening all year. I try to describe it in terms of market math. Valuation is driven by earnings, and interest rates—or more generally liquidity. I think of it as an equation (Valuation = Earnings/Interest rates).
When earnings go up and rates are falling, price goes up. When earnings are going down and rates are going up, price goes down. That's just the market math.
This year, earnings have been growing strongly, but liquidity has been tightening. The Fed has been raising rates and the dollar has been getting stronger. I’ve been writing for some time that the market seemed to be underestimating the path of rate hikes, and the move up in rates seems to suggest that was the case.
At the same time, we have seen the beginning of 3rd quarter earnings season. Some companies have missed their earnings estimates or guided expectations down, blaming tariffs, inflation and the stronger dollar. That creates the sense that earnings growth is peaking. So for the market math, the numerator (earnings) is doing well, but the denominator (interest rates) is not. The result: Market valuation is going sideways to down.
So what does that mean going forward?
Timmer: Earnings are coming off a peak, rates are accelerating, and there may have been some complacency in the market. Put that together and you get a sell-off. But take a step back - the market was up about 10% from June, and has fallen about 4% in recent days. Earnings may be slowing from about 24% year-over-year growth in Q2, to 19% in Q3, but that is still a very high number. And rates are moving up, but I don’t think any move below 3.5% will derail the economy. So I don’t think we are on the verge of recession or a bear market or anything like that.
But there is no denying the math—there are headwinds to valuation. It's been 10 months since the January highs, and while we set new highs recently, they were quickly rejected. My base case is that we are stuck in a range. That doesn’t mean we are in a bear market—earnings would have to fall and liquidity would have to be tight—and we don’t have those conditions. So, I think it makes sense to lower expectations until there is clarity about the end of the rate hike cycle. But as the market goes sideways and earnings grow, valuations are coming down. Maybe we go into next year at 15X earnings, and that could be a good backdrop for the stock market.
Are there risks to the view that the market may stay in a range?
Timmer: Again it comes down to earnings and rates. If earnings prove less resilient than investors hope due to wage costs or tariffs, it would be a negative catalyst. In recent weeks, the Fed has laid out a clear path of 4–5 more rate hikes over the next few years until it gets to a policy stance that is slightly more than neutral. The Fed may have to abandon that path if the economy falters, which would cause the Fed to slow. Or if inflation accelerates north of 2%, or expectations rise, then the Fed would have to accelerate. Those would both be negative for the market.
What should investors think about?
Timmer: For a buy and hold investor, if you are following a plan based on your goals, financial situation, timeline and risk tolerance, you may not want to do anything. If you have a plan but are not allocated according to plan, you should sit down with your advisor and see where you need to be. It may be time to rebalance.
For more active investors, the recent sell-off has been led by the technology stocks, but utilities have done well. If it looks like the market will be under pressure, an investor might consider rotating among sectors, moving out of tech, industrials, and materials to utilities.
In terms of market cap, small caps began underperforming a few weeks ago—a sort of canary in a coal mine. Regionally, emerging market stocks have underperformed the US by more than 20 percentage points in 2018. That kind of gap is very large and at some point that will become a compelling opportunity set, but who knows if we have gotten there.