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Positive signs despite drop

The market has been volatile, but there are reasons to hope things will improve.

  • By Jurrien Timmer, Director of Global Macro for Fidelity Management & Research Company (FMRCo),
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Key takeaways

  • Market volatility has accelerated, with selloffs impacting tech stocks, commodities, and high-yield bonds.
  • Some parts of the market are showing positive relative performance, including emerging markets stocks, which could be a sign that the worst of the selloff is in sight.
  • Market valuations may now reflect changing fundamentals.

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.

The market delivered another big move to investors in the first week of December, with the Dow Jones Industrial Average falling more than 800 points in one day. Risk assets, including stocks, commodities, and credit, have continued to struggle in recent week, but, signs are appearing that suggest that markets may be approaching the end of this volatile period.

Some of the hottest stocks at the beginning of the year have continued to make new lows, with the Facebook, Apple, Amazon, Microsoft, Google basket (FAAMG) now down 25% since early October—more than twice as much as the S&P 500. Crude oil is down $25 to $50 per barrel and high-yield bond credit spreads are making new highs for this cycle. What was a benign landscape in the land of credit is not so benign all of a sudden (although a far cry from what we have seen in the past).

So what are the bright spots? There have been some positive divergences in emerging markets and China, as well as the rate sensitive groups like the homebuilders and even the banks. These are all making higher lows while the momentum/commodities/credit space is making lower lows. Even the economically sensitive CRB Raw industrials Index is hanging in there, suggesting that the global economy may be improving.

What's behind the market sell off

In my view, this selloff (the S&P 500 is down 11.5% since October) is a manifestation of 2 themes, one fundamental and the other more technical.

Fundamentals: Slowing earnings, higher rates

The fundamental story is that the market is coming to terms with a slowdown in earnings growth (and economic growth in general). The estimated year-over-year growth rate for S&P 500 earnings in 2019 has dropped from 12% a month ago to now 9.7%, and if history is any guide it may slide down to 5%. It's not the end of the world, but in the context of a Fed that may only still be in the sixth inning of its tightening campaign it's enough to cause a significant re-rating.

Technicals: Crowded trades are getting washed out

The technical story is that, one by one, the crowded trades are getting taken to the woodshed. In January it was the short-VIX crowd. Now it's the FAAMG (Facebook, Apple, Amazon, Microsoft, Google) trade, as well as oil. Even the previously resilient high-yield credit and bank loans are now under pressure.

Downturns often include a rotation away from what started them (in this case emerging markets and rate sensitives) to the stuff that everybody wanted to hold onto but then had to sell as the margin calls piled up. I think that's what we are seeing here. In the process, the forced liquidation of crowded trades has turned an otherwise orderly correction into a washout. It's an all too familiar story.

The good news: Stock valuations seem to reflect new conditions

The good news is that equity valuations already largely reflect the change in fundamentals. The next-12-month price-to-earnings ratio (P/E) is down to 15.2x, which is a far cry from the 19.7x multiple in late January. But a forward P/E is only as good as the estimated earnings—and there is no guarantee those estimates will be right.

But even the trailing P/E reached a new low of 16.7x last week. That's a far cry from the 21.9x at the peak in January, and not so bad in a 2% inflation world. It's a 23% valuation haircut against an 11% drawdown in price. Is that enough insurance against bad news? We won't know until it's all over, but my guess is that it could be hedged.

With earnings growth getting repriced, the onus is now on the Fed. All we need is for the Fed to “ease” by tightening less, just like it did in early 2016. I'm not holding my breath, but it could happen especially now that credit is on the move along with equities. Equities alone were never going to be enough to sway the Fed, but equities and credit may be.

With growth slowing, credit spreads now widening, and both real rates and TIPS breakevens coming down, the Fed certainly has the cover to guide the market that it plans to space out its remaining 4 hikes over several years instead of several quarters (as Fed Vice Chair Richard Clarida recently hinted). Just a change in expectations of rate hikes could be enough to move the market. If so, watch emerging markets.

Looking a little like 1994

In 1994, the market bottomed as soon as the spread between the fed funds rate and the 2-year Treasury yield started reflecting fewer rate hikes. This was in November 1994 when the S&P 500 suffered its second 10% drawdown in less than a year. The Fed kept raising rates several more times after that but that was the point when expectations peaked. It was all that the market needed to hear.

Ultimately the Fed didn't start cutting rates until July of 1995 (it cut 3 times from 1995 to 1997 and then started hiking again in 1998), but the point is that the market's expectations pivoted and that was enough to get the market going.

In the charts below, I show the 1994 analog for the S&P and for the yield curve. While the 3-month to 10-year curve was far more positive in 1994, when we we normalize today's curve for the much-higher term premium of 1994, we see that the analog becomes much tighter. It's almost a spitting image in fact.

The bottom line

We won't know if 2019 will go the way of 1995, but we do know that a lot of bad news is already priced in by the 23% decline in the market's valuation. That tells me that any positive surprise (like the Fed slowing down its remaining rate hikes) could lift the market.

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