Timmer: The big question for the market

As I've been pointing out in recent weeks, with the market already expecting such a restrictive path from the Fed, it didn't take much to trigger a relief rally. And that's what we saw in the last few weeks—expectations for the Fed's terminal rate (or ending rate for this hiking cycle) came down very slightly, sparking a rally for stocks and long-term bonds.

Even after the market's sharp Fed-induced drop on Wednesday, we're still clearly up from the lows. Bear markets are often littered with face-ripping rallies, of course, so the fact that we saw one should surprise no one.

Whether the October lows hold is anyone's guess. Through last week, the market gains had been decent in technical terms. The percentage of stocks trading above their 20-day moving average had improved from 3% at the lows to 88%. And there was decent price momentum as well, with the percentage of stocks with positive momentum reaching 55% (similar to what we saw during the summer rally).

Reasons for optimism: seasonality, elections, stock prices

There are arguments to be made in favor of the market holding its ground. One comes from theories related to seasonal patterns. According to this theory, the seasonally weak period runs from the summer to mid-October, and then turns positive until the following spring. The recent bottom we just saw fell perfectly in line with that seasonal pattern.

Another reason could be the political cycle. Next year will be the third year of this presidential administration, and third years have historically generated the best returns on average, holding all else equal (which is a huge caveat). And with the potential that control of one or both of the House and Senate could flip in next week's midterms, we may soon be looking at political gridlock, which may be a beneficial backdrop for markets. 

Finally, there's the simple fact that quite a lot of bad news has already been priced into the market. At the October low, the S&P 500 had experienced a drawdown of 28%. Put another way, it had already priced in about 85% of a typical bear market.

Reasons for skepticism: valuations, earnings

However, as I have been writing for some time, the market continues to look overvalued—based on my calculations of a "fair-value" price-earnings (P/E) ratio that would be justified by current interest rate levels.

Following the lift of the past few weeks, the stock market is now even further away from my estimate of its fair value. The S&P 500's actual current P/E ratio is now 16.8 times expected earnings, while its fair-value P/E ratio is at 13.8 times expected earnings (I formulate my estimate of fair-value P/E ratio with a regression analysis that uses the 2-year yield and the 10-year real yield as inputs).

So in my opinion the market is overvalued based on expected earnings, and that's before you factor in the possibility that those earnings estimates could be too high. Third-quarter earnings season is now underway, and at the aggregate level the quarter looks like an average quarter: Earnings estimates had already been reduced, and most companies are beating those reduced estimates.

But behind the beaten estimates is an unmistakable slowdown in earnings growth. If you exclude the energy sector, S&P 500 earnings growth for 2022 is expected to be a modest 1.8%, with risk to the downside.

Are we still in a long-term bull market?

So far, we've been looking at how the market's performance could play out over the short term. But perhaps an even more important question is where we are in the long-term trend.

As longtime readers know, for nearly a decade I have believed we are in the midst of a long-term bull market—one that started in 2009. While the outlook is fuzzy right now, I do still think there's a chance the bull market could be salvaged.

For one thing, it's not unusual to see recessions or shorter-term bear markets even during a long-term bull market. An easy visual of this is the chart below, which shows the inflation-adjusted S&P 500 total return against its long-term trendline (based on a regression analysis). After rallying far above the trendline, the recent bear market has brought the S&P back into balance with its long-term trajectory.

Historically, long-term bull markets have spanned about 18 years on average. So if this is the end of the line for this bull, it will have been shorter than usual.

One important (and often overlooked) driver of this long-term trend has been "financial engineering" by publicly traded corporations, in the form of share buybacks and merger and acquisition (M&A) activity. This activity has helped fuel higher share prices by reducing the number of shares outstanding. Just take a look at the chart below. Since the 2009 low, the cumulative reduction of shares via buybacks and M&A has outpaced the cumulative issuance of shares by about 8-to-1. How could the markets not have rallied so strongly in the face of this supply-demand dynamic?

Will buybacks continue to hold up, and provide more fuel for the bull? One consideration could be interest rates. While many companies buy back their shares because they generate excess cash flow, some have been issuing debt in order to finance buybacks. Higher interest rates could discourage that practice. When considering buybacks as a percentage of S&P 500 revenues, the level of buybacks has been pretty stable since about the mid-2000s. So if buybacks remain strong, perhaps this bull can continue to chug along.

But that still leaves the interest-rate part of the equation. All else equal, low interest rates support higher stock valuations. Interest rates have been in a long-term downtrend for years, which has also been a strong driver of returns during this long-term bull market. Could the end of the low-rate era stop this bull once and for all?

One problem with the bond market's current dynamics is that there are, essentially, no buyers left. Investors—from individuals to pension funds—bought a ton of bonds during the past 15 years or so, with cumulative flows into bond funds and exchange-traded funds totaling $3.6 trillion. Those investors were already "all in" on bonds, and those flows are in reverse now. Central banks, meanwhile, have also stepped aside from the market. This lack of buyers has contributed to the sharp rises in yields we've seen this year.

However, as I've written about before, it is my strong hunch that sooner or later the Fed may step back in as the bond market's buyer of last resort. Perhaps the Fed's involvement could salvage the long-term downtrend in yields we'd seen for so many years. And perhaps, in the process, it could even salvage the long-term bull market for stocks.