- When headlines affect stock markets, the question that investors should ask themselves is, "Is this systemic for the economy and markets?"
- The long-term impact depends on whether this geopolitical development escalates into something that is systemically important to the fundamentals that drive the stock market.
- The fundamentals that drive the stock market are earnings, interest rates, and valuation.
We started the new year with high hopes for a continuation of the recent stock market rally, only to have that complacency shaken by a major geopolitical development overnight (the US drone attack on a senior Iranian military figure, with Iran vowing to retaliate). The result was rising oil prices and falling stock prices, a rally in gold, falling bond yields, and increased volatility. On January 7, Iran fired missiles at US military bases in Iraq. The following day, January 8, stock market indexes rallied following remarks by President Trump.
It comes back to fundamentals for investors
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 immediate question on investors' minds was: Is the rally over? Are we heading for an environment of rising geopolitical risks and therefore falling stock prices? What does it all mean? It all depends on whether this geopolitical development escalates into something that is systemically important to the fundamentals that drive the stock market.
Those fundamentals are earnings, interest rates, and valuation. The question that investors should always ask when confronted with big headlines is, Is this systemic for the economy and markets?
Potential implications in the future
It is clearly much too early to know how events will evolve, but it’s always important for investors to keep an eye on developments that have the potential to affect the fundamentals: the trajectory for US or global earnings growth, interest rates, and Fed policy.
Falling earnings growth would be a negative for the stock market in any scenario, but especially so given how much stocks have rallied recently in anticipation of an earnings rebound in 2020. The market tends to discount the future. At inflection points stocks will often rally even though earnings growth is still slowing. Mathematically this results in an expansion of the P/E ratio, and this has certainly happened recently.
The P/E multiple for the S&P 500 has risen 33% from a year ago (admittedly from a very low level given that the market was down 20% then), while earnings growth has slowed to basically zero. The forward P/E ratio (based on expected earnings) has now climbed to a lofty 18.5x, and that does not leave much room for error should the earnings growth that is now priced in not materialize.
So, that high valuation leaves the market a bit vulnerable over the short-term. Therefore, it's always possible that we will experience a 5% to 10% correction in the coming weeks, depending on how things develop on the geopolitical stage. Corrections of this magnitude happen all the time (about a third of the time historically), and should therefore not deter long-term investors from staying invested.
In my view, ultimately, unless and until the expected earnings rebound for 2020 is in jeopardy, the market should be able to overcome any short-term jitters and continue on its record-setting bull market. With the caveat that future events may eventually affect the fundamentals that drive the markets, my expectation is that earnings will grow around 8% in 2020 despite recent geopolitical developments. This suggests that even if the P/E multiple falls from here, the stock market will likely gain more ground in 2020.
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