An unclear path forward for stocks

Cyclicals and small caps improve slightly but reopening uncertainties cloud the way.

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Key takeaways

  • US stocks continue to churn sideways as cyclicals and small caps show some improvement but struggle with reopening uncertainties.
  • Earnings season has been a mixed bag so far but the global economy could be at or near a bottom of the cycle for earnings growth.
  • Possibly more important than near-term earnings growth, the equity risk premium and the future of buybacks could have critical implications for stock market returns.

Well, here we are, now 6 weeks after the June 8 momentum high, with little progress in the overall market. At 3,224, the S&P 500 Index (SPX) remains just a hair below the 3,233 recovery high, which is 44% above the March 23 low.

The sideways churn is exactly in line with what typically happens following a momentum peak, regardless of the ultimate outcome.

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 spread between best and worst has narrowed a bit, compliments of an impressive downside reversal day in the NASDAQ and some improvement among cyclicals and small caps. Still, the spread is wider than it was at the March bottom, which is saying something. Clearly the challenges facing the US in trying to reopen amid a surge in COVID-19 cases in the sunbelt is holding back the stocks in the "reopen" sectors while boosting the "work-from-home" stocks.

One piece of good news last week was that the Russell 2000 index held its fragile uptrend line. It's a start.

While the S&P 500 made a slight new recovery high last week, breadth is lagging behind. This is very typical and, in my view, is to be expected at this point in the cycle. If this is an early cycle bull market, this divergence should eventually resolve itself in a positive direction. If it turns out to be a top (as it was in February), it will be the warning that will become obvious only in hindsight.

Despite some speculation among day traders, equities remain rather unloved by long-term investors. At −$289 billion for 12-month net flow into mutual funds and ETFs, adjusted for inflation (measured in today's dollars), we remain on par with the kind of selling produced by the global financial crisis (GFC).

Concerned about buybacks

Earnings season is now underway, and, so far, it has been a mixed bag. The Q2 earnings growth estimate did fall from −43.7% to −46.2%, so, all in all, there seems to be some negative guidance going on. But then again, less than 10% of constituents have reported so far.

It certainly appears that we are at or near a bottom of the cycle for earnings growth, as the chart below shows. The question is the slope of the recovery as we head into 2021.

In my view, the shape of the earnings recovery over the next few quarters matters less than the equity risk premium and the state of share buybacks. (The equity risk premium, ERP, is the additional return that investors expect to earn over Treasury bonds or the risk-free rate of return.) For the discounted cash flow model (DCF),* those 2 variables are what really move the needle, as they greatly affect the "terminal value."

On the latter front, it's a bit disconcerting that the pace of announced buybacks for 2020 has not picked up yet in recent weeks. Normally it would have hooked up by now. The chart below shows that we are now in line with 2011 and 2012 in terms of the pace of buybacks.

Perhaps this will change in the coming weeks, but it is worth pointing out that in 2011 and 2012 the buybacks-per-share number was around $41/share. That's only half of the 2019 number, so if this continues it would be a very large haircut.

So let's plug this into my DCF. If I adjust my model to reflect this lower track of buybacks, I get the following 4 scenarios.

On the top, I am assuming for now that the consensus earnings estimates (from Bloomberg) are correct. That is, $127 for 2020, $159 in 2021, and $187 in 2022. On the left I am assuming that the payout ratio will remain at 90%, which is where it has been in recent years, while on the right I am assuming that it will fall to 70%, which is what would happen if buybacks drop from $80/share to $41/share.

On the bottom I am assuming a more swoosh-shaped recovery, with a payout of 70% (the course that we seem to be on now) and 60%.

For now, I view the most likely scenario as a swoosh-shaped recovery with a 70% payout. I think this is a realistic assumption given the downside risks to growth as many states roll back their reopening plans, plus, further out, the potential that corporate taxes, which were significantly reduced in 2017, might rise back up in coming years, if there were a political regime change in Washington.

If I apply various equity risk premiums to this scenario, I get the following:

  • At an ERP of 4.5% I get a fair value of 2,800, which is 13% below current levels.
  • At 5%, the fair value falls to 2,500.
  • At a 4% ERP, fair value rises to 3,150.

To me something like 2,800–3,200 seems like a reasonable trading range for the SPX, which means that we are currently at the high end of the range. Other than the potential for effective COVID-19 treatments or a vaccine, I don't see much upside here.

If the pace of announced buybacks picks up in the coming weeks, then that will lift the whole risk range by several hundred SPX points. But this is how it's looking now. Of course, if the consensus earnings forecasts are correct, then even at a much-reduced payout ratio of 70%, the fair value would be 3,224 at a 4.5% ERP, which happens to be exactly the level at which the SPX is trading now. It shows how efficient the market is, given the currently available consensus earnings estimates.

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