Interest rates, liquidity, and stocks

The Fed will eventually take away the punch bowl—does that mean the party will end?

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

  • On the surface, stocks are in a holding pattern as investors wait for the June Fed meeting. Any hints about tapering the quantitative easing program and the timing of interest rate increases will be key for markets.
  • Valuations have been driven up by low interest rates and high liquidity provided by the Fed. Absolute valuation is affected by the timing of the market cycle and is also a function of liquidity growth, interest rates, and the payout ratio (dividends plus buybacks).
  • Liquidity is high, interest rates are low, and the payout ratio remains very high—these 3 factors currently support high valuations.
  • To see how the markets could respond to less liquidity and higher interest rates, we can look back to 2010 after the global financial crisis. Metrics like the price to earnings ratio (P/E) may start to compress but that doesn't have to happen at the expense of stock prices.

While the S&P 500 (SPX) has been meandering around the 4,100 level since April, there has been a lot of churn beneath the surface, with the highest flyers rising to truly spectacular levels before crashing back to earth.

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.

Such are the extraordinary times in which we live. Combine a war-like fiscal/monetary cocktail with meme culture, a technological revolution, and a pandemic, and we get a market cycle that none of us will soon forget.

Earnings are taking over from valuation

While the former highflyers (now also including crypto) are crashing back to earth, what is most impressive to me is that the broad market has so far been left unscathed. Six months ago, the easy conclusion would have been to expect the fall of the FANGS* to take the whole market down with it. That has not happened. Instead, the tape has broadened.

But what about valuation? After all, most valuation metrics are in the upper percentiles of their historical ranges. I think the answer is somewhat nuanced.

First, we are a year into a new bull market cycle and have arrived at the point where the baton is being passed from the valuation-driven phase of the rally to what I believe is a more sustainable, broader-based, earnings-driven rally. If that's the case, valuation multiples, like the price to earnings or P/E ratio, should be coming down from here, but that does not need to come at the expense of price.

The chart below illustrates this. It shows the interplay between valuation and earnings growth. Note the similarity between the current cycle and the global financial crisis.

In March 2009 the S&P 500 finally bottomed after a 57% decline. As is typical for this type of cycle, price bottomed several quarters before earnings. The blue bars in the bottom panel show the year-over-year (YoY) change in the P/E ratio and the orange bars show the YoY change in earnings per share (EPS). Note how changes in earnings and valuation tend to be almost a mirror image of each other. The dark blue line is the YoY total return for the SPX.

During the early stage of the bull market (from March 2009 to April 2010) the rally was driven by "junk" (low-priced, over-levered) stocks. By the time that earnings growth flipped from negative to positive, the annual return for the SPX had already peaked. What followed was a 13% correction in real terms from April 2010 to July 2010 (with the end of the quantitative easing, or QE1, being the catalyst), before the market cycle matured into a more sustainable mid-cycle advance.

We seem to be at the exact same place now, with earnings growth flipping positive while valuation is peaking. With the current focus on rising inflation and what that means for the Fed, the backdrop is similar to 2010.

The next chart shows the forward price-to-earnings (P/E) ratio. While the P/E multiple today is much higher than in 2009/2010, the degree of multiple expansion is similar (approximately +50%). As earnings growth now goes from negative to positive, history suggests that the P/E multiple may compress, resulting in a more moderate pace of price gains (more in line with historical averages).

But what about the absolute high level of valuation? (Absolute value methods measure how much a business is worth based on its expected cash flows. The discounted cash flow model, or DCF, or a variation, is often used to determine absolute, or intrinsic, value.)

Here we need to keep in mind that valuation is not only affected by the timing mismatch of the market cycle around inflection points, but is also a function of liquidity growth, interest rates, and the payout ratio.

We know that interest rates are very low, liquidity is ample, and the payout ratio (dividends plus buybacks) remains very high at around 90%. All 3 of these factors support above-average valuations.

Assuming that the current high payout continues, the valuation puzzle will likely come down to interest rates and liquidity. As was the case in 2010, both factors are at risk of becoming less favorable over the near term as the market's attention increasingly focuses on when, and by how much, the Fed will normalize policy.

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