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 S&P 500® recently breached the 3,000 level for the first time ever. Meanwhile, the Federal Reserve delivered the first of possibly several "insurance" cuts to the federal funds target rate, right as the pivotal Q2 earnings season is in full swing.
Earnings growth peaked last year at +24.5% in the third quarter and has slowed to a barely positive +0.6% growth rate in Q1. That performance is likely to repeat in Q2 and Q3, in my view. So far, with 77 companies reporting (as of July 19), the Q2 estimate has bounced 150 basis points (bps) from its low of −2.9%. While that’s consistent with the typical earnings-season bounce, the risk is that it comes at the expense of Q3. Indeed, the consensus estimate for Q3 recently dropped 40 bps in a single week.
Meanwhile, the calendar-year 2019 consensus estimate keeps falling and is now down to a year-over-year (YOY) growth rate of +3.7%. At the start of the year that estimate was +8.3%. The Street is expecting a V-shaped recovery into 2020 (to a +11% YOY growth rate), but at this point, with tariff uncertainties dragging on, I think it's possible those expectations may be too high. The risk for equities is that the expected V-shaped earnings recovery turns into an L against a valuation backdrop (17.3x forward earnings) that I think doesn't leave a lot of margin for error.
In this environment, a proactive Fed willing to cut interest rates 1990s-style may be just what the economy needs to extend the business cycle even further—and for the stock market to lift itself out of its now 18-month-long holding pattern. Remember: The S&P 500 price index peaked in January 2018 and has made little progress since then. But in my opinion, it all comes down to the interplay of the 2 forces of growth and interest rates—and where that leaves valuations and therefore prices.
It's hard for me to believe that the Fed is poised to ease less than a year after it was guiding markets toward a more hawkish path. Specifically, I find it fascinating that the Fed may be about to cut rates at the same time that the output gap, or the difference between actual and potential GDP, has been positive and on an upward trend. At the bottom of the global financial crisis in early 2009, the output gap was −5.8%. It crossed back over to the positive side last year and has been steadily rising, standing at +0.8% as of this writing. When has the Fed ever cut rates in such an environment?
Well, it happened in 1995 and 1998, both of which instances were, in my view, insurance cuts that served to extend the business cycle.
Furthermore, the Fed is cutting rates during a period when the stock market has been running at all-time highs; financial conditions appear benign; credit spreads are holding steady; and the CBOE Volatility Index (VIX), aka the "fear index," has recently been trading at a mere 13. This is a pretty bullish backdrop that makes one wonder why the Fed would cut rates at all. I, for one, don't sense a clear and present danger.
Indeed, when I consider all of the Fed's easing cycles over the past century, narrowed to those where economic and financial conditions were as benign as they seem to me today, I come up with 6 rate-cutting cycles: 1954, 1960, 1984, 1989, 1995, and 1998. In 5 of the 6, the S&P 500 was higher 12 months later—by an average of 22%. Those are good odds, in my opinion; however, the important caveat is that the current cycle began in 2007, just ahead of the global financial crisis. So why is the Fed easing rates if things seem OK?
I think, ultimately, it's all about inflation, or lack thereof. The Federal Reserve's favorite inflation gauge, core PCE,1 has remained persistently below the Fed's 2% target, despite a 50-year low in the unemployment rate and all that is supposed to mean for the Philips Curve, which measures the trade-off between employment and inflation. Core inflation currently sits at 1.6% (year over year), down from 2.0% a year ago and lower than one would expect during an economy's late-cycle phase. This lack of inflation pressure allows the Fed the option to let the economy run hotter than it might otherwise allow, as well as to more or less capitulate to market pressures without worrying too much about unleashing inflation expectations.
Also, although the US economy remains robust, it's clear to me that the global economy has been slowing for more than a year and that the US is finally following suit. The JP Morgan Global Manufacturing PMITM (a measure of the global economy) has fallen from its 54.4 peak in December 2017 to a recent new low of 49.4 as of June 2019. Despite its relative health, the US economy has been slowing, joining the rest of the world. The US ISM Manufacturing Index (similar to the PMI index) peaked a year ago at 60.8 and is now down to 51.7 (a reading below 50 would suggest contraction in the manufacturing sector). We have been seeing the same trend in corporate earnings, with uncertainties around tariffs clearly playing a role.
Meanwhile, the so-called natural rate, or R-Star (a theoretical interest rate at which the Fed is neither too restrictive nor too accommodative), has started to decline slightly, after gaining ground since 2017. As of March, the quarterly Laubach-Williams series2 is at 0.4% (adjusted for inflation), down slightly from its 0.6% level a year ago. Not the end of the world by any means, but between the global slowdown, the softening natural rate, and a complete lack of inflation expectations, the Fed seems to have a free option to execute a couple of insurance cuts to keep the business cycle going with little fear of inflation.
Seemingly channeling the more intuitive, less model-driven Greenspan Fed from the 1990s, today's Federal Reserve probably assumes that it can always tweak policy in the other direction if the economy reaccelerates from the current slowdown. I think that is correct. As I mentioned earlier, the stock market is always about growth and rates. If growth reaccelerates in 2020, the market is not going to mind if the Federal Reserve takes back the insurance cuts that now appear to be on the table.
The combination of new highs for the S&P 500 and decelerating earnings growth inevitably means that valuation multiples are expanding. The 12-month forward price/earnings (P/E) ratio has now expanded to 17.3x, up almost 4 points since the December low but still 2 points below the high set a year and a half ago when the S&P 500 first stalled out.
My base case is that the Fed will indeed be able to extend the cycle and that earnings growth will improve as we move into 2020, albeit not to the levels that are currently priced into the market. The result is some additional upside for stocks, but with valuations already on the high side, it likely won't be the same kind of "melt up" that we saw in 1999.
The secular trend
I have been writing about the potential for this cycle being part of a secular bull market since 2013, when the stock market first started making new all-time highs following the "lost decade" of the 2000s. 6 years later, let's revisit that thought once again.
Secular bull markets are prolonged "super cycles," which span several decades and produce outsized returns versus history. They comprise a number of 4- to 5-year market cycles and include corrections and bear markets. But secular bull markets differ from the market's "central trend"—the 10% trend-line return spanning the market's entire history—in that the underlying market cycles have a steeper upward slope and a right-leaning skew. That's a fancy way of saying that a super cycle goes up further and longer with shorter and shallower corrections than does the typical market cycle. While the market's central trend is for a 10% average annual return with a 25% to 30% bear market every 4 to 5 years, secular bull markets produce an 18% compound annual growth rate lasting up to 2 decades with smaller corrections along the way.
With the S&P 500 now up 397% since its March 2009 low near the end of the global financial crisis, this bull market looks a lot like the secular bulls of 1949–1968 and 1982–2000. Those 2 periods each produced an 18-year run of 18% average annual returns, very much like the current market cycle has delivered so far. We can all argue whether or not this is indeed a secular bull, and we won't know until many years from now, but one thing is clear: This market cycle continues to look, feel, and act like a secular bull. If the analog holds, we might be in store for rising stock prices for at least another 5 years.
There's always another side to the story, however: If there weren't, the market wouldn't have both buyers and sellers. For example, countering the secular bull thesis is the valuation argument, namely economist Robert Schiller's trailing 10-year cyclically adjusted P/E (CAPE),3 which shows a consistent negative correlation to the 10-year forward rate of return. In other words, intuitively, the higher the stock market’s current valuation, the lower its future gains. The CAPE model suggests that future equity returns are likely going to be paltry (low- to mid-single digits), which directly contradicts the secular bull market analog suggesting strong double-digit returns.
It's interesting that from 2009 until 2019, both the secular roadmap and the CAPE model were in agreement, both displaying bullish implications (mostly because 10 years ago the starting P/E was very low following the global financial crisis). But now, with the weak earnings numbers from 10 years ago (2009) weighing on the CAPE—that is, pushing the P/E upwards—the 2 models are parting ways. Note that if nothing else happens to price, the CAPE will soon fall from about 27x to a still-high 21x as the 2019 numbers push the 2009 numbers off the back of the model. Regardless, the roadmap based on the average secular bull market continues to suggest healthy returns for another 5 years or more, while the CAPE model shows positive but very modest forward returns. We will see which is right. My guess is that it's somewhere in between.
With investors' focus on cash flows (given today's low, low interest rates) along with relatively high-versus-history cash yields (stock dividends plus share buybacks) putting the S&P 500 in a better light than does just the P/E multiple, my sense is that the high CAPE is not telling the entire valuation story. Besides, while the secular analog disagrees with the CAPE model in terms of magnitude, both measures agree on the stock market’s long-term direction, which is up.
A final thought: First we had the dot-com bubble that burst in 2000, then the housing bubble that burst in 2008: Bears like to label today's market an "everything bubble." The current run-up is blamed on central-bank profligacy, with ZIRP (zero interest-rate policy) and QE (quantitative easing) leading to the "TINA" trade—There Is No Alternative (to stocks)—with equity returns further inflated by share buybacks. All of these points may be valid, but nevertheless if we take a step back and compare the S&P 500 against its long-term central trend (its 10% average annual growth rate stretching back more than a century), we see that currently the market is only 10% above this trend line. Note that at previous "bubble tops," the market was about 100% above its trend line; so, a 10% premium doesn't seem that alarming to me.
All in all, the combination of the secular context against a Federal Reserve that is aiming to extend the business cycle tells me that this 10-year-old bull may well have some life left in it.
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