- A 60/40 index is now back at February's all-time high. Chalk it up as a win for those investors who were able to ride out the storm.
- The market has broadened out significantly as the economy is showing signs of recovery. It's what you want to see in a bull market.
- Market sentiment remains skeptical, which provides even further fuel for the 43% rally.
- Stock prices have now recovered more than the earnings projections. Something needs to give.
- Either the market needs to correct, or the earnings estimates are too low, or valuations remain elevated as a result of the Fed's market interventions. Maybe we'll get a combination of all 3.
Last Friday's broad-based melt-up following the blockbuster jobs report may well turn out to be a bookend to the broad-based selling crescendo of March 23. Whoever was still fighting the tape and blaming everything on the Fed pretty much had to throw in the towel last week and accept that, yes, things are starting to get better in the economy, or at least less bad. It's always about the second derivative, or rate of change, at turning points.
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.
Persistent negative sentiment has been a hallmark of this now 43% rally, and Friday's action shows how dramatic a short squeeze can get. The tape isn't always right, but, in this case, it has foretold things pretty well.
A 60/40 index is now back to February's all-time high. Chalk one up for those who rode out the storm.
The recovery is broadening
Back in April the market's recovery had looked a little "off" because the gains were led by only a handful of large companies. As a result, we never got the kind of "breadth thrust" that often provides confirmation that a new cyclical bull market is underway.
But things improved last month when small caps and cyclicals came to life and enabled the leadership to finally broaden out. As a result, the dispersion between large caps and small caps, growth and value, winners and losers, has narrowed significantly.
This is a good sign and it's one of the reasons why the market is up so much. The pie has gotten bigger, and in the process has dragged the S&P 500 to levels few of us imagined a month or two ago.
Sentiment is mixed
After this melt-up, one would be forgiven for assuming that investor sentiment is now ebullient as every last skeptic has capitulated to the long side. Far from it. While some sentiment surveys show a retreat from the bearish extremes set back in March, equity flows are still negative (just less so), while the surge into money market mutual funds (MMMFs) has only barely abated. Assets in MMMF assets are around $4.75 trillion after peaking at $4.80 trillion a week ago. Lots of dry powder still.
There is also evidence that some hedge funds continue to press their bearish bets, so the bears have not yet capitulated en masse.
Earnings and valuation
So where does this leave us? Was Friday's capitulation the end of the momentum phase of the rally, just like the March 23 low was the end of the liquidation phase? I don't know. Given the strong tape, committed Fed, and lack of bullish sentiment, I doubt that this rally is over.
But it could very well need to (and probably should) take a breather here, much like it did in 2009 after it gained about this much and for this long.
After all, the 43% gain in the S&P 500 (SPX) has left the market a little lopsided in terms of earnings and valuation. The price-to-earnings (P/E) ratio using 2022 estimates is now at 17.0x. That's 6 points above the March lows and slightly above the 15.7x at the February peak.
The equity risk premium (ERP), the additional return that investors expect to earn over Treasury bonds, is now down to around 3.5%. That's not outlandish, but it is below what the Volatility Index (VIX) would suggest. The implied equity risk premium tends to bounce around a lot but the realized equity risk premium is between 4% and 6%, depending on the approach and time frame.
In my view, in a TINA world (There Is No Alternative), a 3.5% ERP against a backdrop of massive Fed support wouldn't be the most shocking outcome.
On the earnings front, with the SPX now only 6% below the February high, it is well above the 14% drawdown in the 2022 estimate (from the February high). That, in my opinion, can only mean 3 things: either the market needs to correct, the forward earnings estimates are too low, or valuations will remain elevated as a result of the Fed's market interventions. Maybe we'll get a combination of all 3.
What if earnings estimates are too low? As we all know, the typical estimate progression is downward—but not always.
During the bear markets of the dot-com cycle and the global financial crisis (GFC), earnings estimates plunged. At some point they ended up being too low. That happened in both 2002/2003 and again in 2009/2010. With the current cycle being much more truncated (or at least that's the hope), is it possible that the 2022 or even the 2021 estimates could drift higher from here instead of lower?
Perhaps the disconnect between price and earnings is that it's just a timing issue. In other words, if price leads earnings (as we know it does), then maybe price is just faster than the consensus earnings estimates are in terms of pricing in the future. To me, especially with the lack of guidance currently coming from companies about their earnings prospects, it's plausible that the earnings data are just too slow to catch up to price.
With that in mind, I wanted to look at the post-GFC recovery to see if there is any precedent for the notion that price is justified in gaining more ground, and doing it faster than earnings estimates. Back then, the market did correctly lead the earnings recovery, but the price line never went above the earnings line as it is now doing.
Once the market was in recovery it only went up as fast as the earnings projections. That is not the case now. By definition, that means that the valuation picture is different this time around (i.e., the P/E is higher and the ERP is lower).
Perhaps that difference can be explained by the chart below, which shows the Fed's QE back then versus now. The balance sheet is growing bigger faster, and so is the market's response function and valuation. Maybe that's all we need to know.
The bottom line
The tape is strong, the Fed is all-in, the COVID curve, for now, has flattened, the rate of change for the economy has bottomed, and sentiment is far from bullish. It's what young cyclical bull markets are made of. But unless the longer-dated earnings estimates are too low, following a 43% gain the market is far from a lay-up at these levels. Maybe it's time for this bull to take a rest. We all need it.