- Despite a record-breaking unemployment report and falling earnings estimates, the US stock market is now just 17% under the all-time high.
- The S&P 500 seems to be in line with current estimates for 2021 and 2022—but those estimates may be too optimistic. Further rallies may require a higher valuation multiple or improving estimates.
- For now, the worst-case scenario for the stock market seems to have been averted by monetary stimulus from the Federal Reserve, but there are concerns that massive "money printing" could spur inflation.
- Japan offers a case study for long-term quantitative easing programs and a negative interest rate policy. They have no inflation despite the huge growth in the monetary base.
Many may be wondering about the apparent disconnect between Wall Street and Main Street. Certainly the current cycle is unique.
The market appears to have bottomed on March 23 (34 market days ago), and is up 26% from the lows (retracing 52% of the decline) as of the close on May 13. But the economic damage continues to mount: Last Friday's jobs report showed a 1-month increase in the unemployment rate from 4.4% to 14.7%. And Q2 2020 earnings are now expected to fall 42% from a year ago. Earnings are on track to fall 21% for the fiscal year.
Stock prices are up though earnings estimates are down
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.
If there is one thing we know, it's that price leads the fundamentals. History teaches us that markets discount the fundamentals, and that "don't fight the tape" and "don't fight the Fed" are often 2 good rules to invest by. Both the Fed, and to a lesser extent the tape, have been on the side of the bulls.
But given the uncertainty of the speed and shape of the economy's re-opening, and how much the market has already rallied, it's certainly logical to ask whether investors have priced in too much of a recovery.
Are stock prices reflecting too much optimism?
The chart below tries to answer that question. Here I show the drawdown and subsequent recovery in the S&P 500 (SPX) price index, overlaid against the drawdown in various earnings estimates. Those include fiscal years 2020, 2021, and 2022, as well as the next 12 months (all data from Bloomberg).
The chart clearly illustrates how price has moved well ahead of earnings, in both directions.
If we just eyeball where the market was trading at the low (2,192 on March 23) versus where it closed last week (2,930), we can conclude that at the low the market was pricing in a bigger earnings hit than has so far materialized (34% decline in price vs. a 27% decline in 2020 earnings per share estimates). Now it is pricing in a recovery—but how much of a recovery?
As of last week's close, the SPX had retraced 62% of the decline and was just 14% below the all-time high of 3,394, while earnings estimates continue to fall. The drawdown in the 2021 earnings per share (EPS) estimate is −16%, and the 2022 estimate is −13%. That lines up quite well with the −14% drawdown for the SPX.
I think we can safely assume that the 2021 and 2022 EPS estimates may be too optimistic—and the declines of the past few days seem to be acknowledging as much. Estimates usually are too optimistic, after all. So, let's assume that they are 10% too high. That suggests that the market is 10% too high as well.
Bottom line: The market has rallied a lot, and if it rallies any more from here it will require either a higher valuation multiple or improving earnings estimates.
To learn more, read Viewpoints on Fidelity.com: What shape will the recovery be?
Fed stimulus helped stocks recover—will inflation result?
The Fed may have helped the stock market avoid the worst-case scenario, at least for now. But at what price? Will all this money printing stoke inflation and debase the dollar?
These concerns are very much reminiscent of the Global Financial Crisis. The gold bugs were out in full force back then, calling for much higher gold prices and pointing out that the gains in the SPX after the March 2009 low were a "money illusion" created by the Fed.
All you had to do was divide the SPX by gold to get an index denominated in "real" money instead of fiat money.
The market recovered as soon as the Fed started printing money, but the magnitude of the recovery was "inflated" by lowering the value of the dollar. In gold terms, the stock market didn't do as well as it did in nominal terms.
It's an interesting argument that is hard to argue with intellectually. Yet in 2009, eventually the market did fully recover and then some. It ended up increasing 5-fold, far more than the Fed's balance sheet would suggest.
The bears would make the counterpoint that the Fed's quantitative easing (QE) and zero interest policy facilitated an era of financial engineering which led to some $5 trillion in share buybacks. It's certainly a fair point.
Consider Japan: No inflation despite negative rates and monetary stimulus
The other analog is Japan. What can we learn about the Japanese experiment with negative rates and debt monetization?1 It's an important question, because demographically the US is about 15 years behind Japan.
The Japanese central bank, the Bank of Japan (BoJ), has been buying Japanese government bonds for years, i.e., quantitative easing. The country has also had a negative interest rate policy since 2016. Banks pay the Japanese central bank to hold excess reserves.
What strikes me is how a massive increase in BoJ money printing (to 104% of GDP) has not created any inflation. The monetary base has grown from 17% of GDP to 94% of GDP and the 5-year inflation rate is zero. Zero! It tells me that the 2-headed monster of debt and demographics is likely deflationary, no matter how much money printing is going on.
Read more about the potentially deflationary effect of an aging population in Viewpoints on Fidelity.com: What's ahead in the 2020s?
Like the BoJ, the Fed has undertaken a massive QE program. And negative US yields may not be out of the question. This was highlighted last week when the June 2021 fed funds contract traded above par, which is a fancy way of saying that it's pricing in a slight negative policy rate. If that's not Japan-like, I don't know what is.
Bottom line: The US is not Japan, culturally nor economically. But demographically the similarities are striking, with Japan 15 years ahead of the US. If the US is going down a Japan-style modern monetary theory2 (MMT) path, the first reaction might be to expect runaway inflation as the Fed prints money to monetize the debt, and in the process debases the dollar. It's a logical view and it may well happen, but it's not borne out by the Japanese analog. Something to keep in mind.