Great expectations in the stock market

Amid sadness and anxiety, there is some news to be optimistic about.

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Key takeaways

  • The stock market continues to recover amid signs that economic conditions are getting less bad.
  • But after a 40% rebound, the market is now technically overbought. That suggests that some consolidation is in order.
  • Earnings estimates for the next 2 years are very optimistic but the recovery from the Global Financial Crisis (GFC) shows that it may not be impossible.

We continue to live in a time of contrast and confusion. It’s saddening to see the country in such a state of conflict and unease.

There is some good news, however, which is that the COVID curve appears to have flattened in many parts of the world (including the US), which, in turn, has allowed parts of the economy to start to open back up and come back to life.

Early signs are encouraging that the rate of change is going from more-bad to less-bad, at least in terms of earnings growth and economic activity.

Evidence for optimism

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.

While the pace and breadth of the economic devastation wrought by the COVID crisis is almost without parallel, things seem to be starting to improve at the margin, again, at least economically.

Case in point: While millions of Americans remain without jobs, continuous jobless claims have turned less bad by falling from 25 million last week to 21 million this week. It’s a start and hopefully the beginning of a sustainable recovery.

A similar data point is the 10.5% increase in personal income last month, against a 13.6% decrease in personal consumption. Fiscal relief in the form of the CARES Act combined with closed shops and restaurants and grounded airplanes have apparently led to an increase in savings and disposable income.

The US savings rate soared to 33% in April, as disposable income gained $2 trillion and personal savings increased by $4 trillion. Hopefully that will help create a V-shaped economic recovery that can match the V-shaped market recovery.

Many investors are still wary

As for the markets, we remain very much in pain trade mode, fearing a broad reversal that catches everyone off guard, with the S&P 500 (SPX) now up 40% from the low and retracing 71% of the decline.

My sense is that most investors missed the low and now worry that the market is over its skis in terms of expectations for a V-shaped recovery. That sense of caution is amplified by fear that the reopening will cause a second wave, and in the process turn a V into a W.

It’s a justifiable concern, of course, but in the meantime the tape does not lie. As of last week, a whopping 94% of stocks in the S&P 500 were above their 50-day moving average. That is the highest level in 20 years! Don’t fight the tape.

Now, a 94% reading is by definition very overbought, so that suggests some consolidation is in order in the coming weeks. Plus, we reached the 200-day moving average last week, which should also act as a ceiling for now. But overbought in a bull market is something entirely different than overbought in a bear market rally.

The disconnect between what the market is doing versus what it should be doing makes for a good conversation between technical analysts and fundamental analysts. As a practitioner of both disciplines, this is always a debate that is playing out in my head.

If the tape represents the collective unconsciousness, wisdom, and memory of all those who have traded before us, then I, for one, want to respect what it says. The market isn’t always right—far from it—but, in my view, it is probably more often right than wrong. Collectively it knows a lot more than we do individually. This is why we look at charts.

Meanwhile, the Fed continues to pump liquidity into the market, with a promise to do much more if needed. Don’t fight the Fed. The Fed’s balance sheet is now $7.1 trillion.

But what about earnings? Are expectations too high, and will that leave the market wrong-footed if and when earnings estimates get revised down? The 2021 and 2022 earnings estimates seem pretty ambitious at $160 and $187 (compared to $127 for 2020), and historically they tend to get revised lower by around 10%. If that happens again, the market’s price-to-earnings (P/E) ratio will be even higher than it already is.

Historical clues

Currently, the street expects a 50% increase in earnings over the next 2 years from this year’s expected level. Those are some high expectations, for sure.

But before we say, “that’s too good to be true,” in April 2009 (1 month after the end of the GFC bear market), the consensus expectation was for a 58% increase over 2 fiscal years. As someone who lived through that crisis, I can tell you that not many people would have believed those numbers in early 2009, just as not many people believe today’s numbers.

As optimistic as analysts were in 2009, they were actually not bullish enough. In May 2009 the realized 2-year gain for S&P 500 earnings was 73%. The 18-month gain was 51%, and the 12-month gain was 29%. The SPX index itself gained 88%, measured from February 2009 (price leads earnings, which is why the months don’t line up exactly).

This is an important reminder that while there is usually a negative drift in the farther-dated earnings estimates, this doesn’t necessarily apply at major cyclical inflection points. Whether the current cycle can match the recovery from the GFC is unknowable right now, but it’s possible that the 2022 earnings estimates (that the current V-shaped price recovery seems to be based on) could be correct or perhaps even too low.

If it’s the latter, the market could have more upside and even be back at new all-time highs in the coming year or so.

So where does this leave us? Maybe the estimates are too high and the market is way out over its skis. But maybe they are not. For now, let’s see how the market holds up as that very-overbought technical picture gets worked out in the days and weeks ahead.

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