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.
Is the market right and does it "know" something that the average investor can't yet see? Is a recession, or worse another financial crisis, around the corner, but we just don't see it yet in the data? Is QT (quantitative tightening) finally wreaking the havoc on risk premia that deep down we all suspected it might?
Or is the market blindly and incorrectly overreacting to the current late cycle narrative of a tightening Fed, a flattening yield curve, and slowing growth, and pricing in a recession scenario that isn't going to happen, at the same time that forced selling by momentum traders is having an outsized impact resulting from the current lack of liquidity?
My sense is that it's the latter, made orders of magnitude worse by the combined technicals of forced selling and poor liquidity. If you look at the 4 phases of the business cycle, it's easy to assume that a recession follows late cycle just like night follows day. But it doesn't always happen like that, especially this time around when the Fed is now very much tuned into the downside risks.
Just like that, what seemed like a run-of-the-mill correction of 10% just a few weeks ago has now nearly turned into a 20% bear market. At Friday's low of 2409, The Standard & Poor's 500 is down 18% from its September high of 2940.
In turn, the countless headlines that may follow should the market fall below the 20% bear market threshold could make investors question whether to sell stocks at a time when they should probably be considering the opposite (rebalancing into a down market is generally a good strategy).
In this sense, it is worth remembering that not every 20% bear market turns into something worse. Sometimes it may be better to buy when the market is down 20% as opposed to using it as a confirmation that things are about to get worse.
For example, in the summer of 2011 the S&P 500 was under pressure because of the debt ceiling debacle and the euro zone debt crisis. By October, the index had fallen 300 S&P points from its high of 1371 set 5 months earlier. Then in early October, the S&P 500 finally crossed the 20% bear market line, only to bottom a few days later with a drawdown of 21.6% and then gaining back 200 of the 300 points in about 3 weeks. There was no recession and in retrospect it was just a bad correction and not the start of a bear market. In 2013 the S&P was up 32%.
Similarly, in 1998 the S&P 500 had fallen 22.4% in only 3 months, but again shortly after crossing over the 20% threshold it snapped back and was at a new high in a mere 7 weeks. That was the period of the Russian default and Long-Term Capital Management, but again there was no recession (although the Fed did ease 3 times in Q4 of 1998). In 1999 the market was up 21%.
And of course there's the 1994 analog. By now that no longer seems like the perfect analog, now that the S&P 500 is down 18% instead of the mere 10% drawdown back then, but nevertheless the similarities remain striking in other ways. Remember, in November of 1994 when the market was down 10% and 2/3 of the S&P 500 was in bear market territory (hence the term "stealth bear market" when describing the 1994 cycle), it was probably a stretch to think that the market was about to skyrocket higher. Yet that's exactly what happened. As soon as the Fed backed off, The Standard & Poor's 500 Index went from a 10% drawdown in 1994 to a 35% gain in 1995. Seven months later the Fed was cutting rates.
Now, I am not suggesting that the same will happen here, and history is of course replete with examples where a 20% decline turned into something much worse. But the point here is that it is not a given that the market has to go from bad to worse once it falls below the magical 20% Maginot Line, and it is also not a given that a recession will ensue. It's just a number.
And this is especially true when the technicals play such a large role, i.e. when there is little or no liquidity to absorb the selling pressure, as is the case today. Poor liquidity exaggerates moves because there are fewer buyers to step in when sellers are selling. I seriously doubt that the market would be down much more than 10-15% if there was healthy 2-way liquidity right now.
I am saying this now, at a drawdown of 18%, because I suspect that if stocks do end up falling 20% the barrage of headlines that will undoubtedly follow might lead some investors to assume that the jig is finally up and that they should sell everything. I think that would be a mistake.
Just to give you a sense of how much and how quickly US stocks valuations have dropped, take a look at these rather stunning stats:
At Friday’s close, the trailing price/earnings (P/E) ratio for the S&P 500 has now fallen to 15.3x, which is more or less the long-term average going back 100+ years, and well below the kinds of multiples that tend to prevail during periods of low and stable inflation (the rule of 20 suggests that the P/E ratio should be 18x).
Not only is the P/E 28% below the January peak of 21.9x, but it’s also below the 19.5x multiple back in August 2017 when the tax cuts started to get priced in to the markets, and also below the 18.0x multiple on Election Day 2016, before the animal spirits supposedly returned to Corporate America.
The NTM P/E (using next 12 month earnings estimates) is down to 13.9x. Wow, a 13-handle! It was 15x just a week ago. That's down substantially from the January peak of 19.5x. Even assuming that the NTM EPS estimate of $173 is $5 too high (given the usual downward drift in estimates) the fwd P/E is still a very reasonable 14.3x.
Meanwhile, the equity risk premium (defined here as the forward earnings yield minus the 10-year Treasury yield) has almost doubled from its level of 2.5% in January to now 4.3%. That's in line with the historical average.
Credit spreads have undergone a similar derating. High yield spreads bottomed at a mere 317 basis points (bps) on October 3rd and are now at 511 bps. The fed funds forward curve is now pricing in NO additional Fed hikes for the cycle. Period.
And all this is happening in an economy that's growing above potential. Unreal.
Even for someone who has been in the markets for 3 decades these changes seem remarkable.
If the reversal of the QE (quantitiative easing) era (called QT) means that the ultra-low risk premiums of recent years get brought back down to earth, well, it has happened! And in only 2 months! Both the P/E ratio and equity risk premium are back to their historical average.
The only risk premium that is still very low is the term premium for treasuries. With the 10-year yield back to 2.8% and inflation expectations back below 2%, the real yield has fallen enough to keep the term premium at full-on QE levels (i.e. at negative levels). So it has been a de-rating but only of risk assets relative to safe assets.
I do think the Fed is getting a bum rap in getting all the blame for the current market swoon. Chairman Powell clearly said that the Fed is watching financial conditions closely (i.e. stocks and credit) and will hike 2 more times ONLY if GDP grows at their expected 2.3% and inflation stays at 2% next year. That clearly implies that if economic or financial conditions fall short of expectations that the Fed will slow down or stop its hiking plans. That doesn't sound hawkish at all, and it certainly doesn’t sound like a policy error in the making. Besides, if the Fed is right and growth does materialize I believe it will be well-justified to keep hiking anyway.
But the Fed is getting blamed for QT, which is on autopilot and not up for negotiation. It remains a difficult to- quantify phenomenon that frankly has been poorly explained by the Fed, other than to say that it is benign. It may well be, but nobody really seems to know.
So will we see the 20% Rubicon getting crossed soon? Will the bleeding continue into year-end, given that liquidity has all but disappeared for the year? Does that mean that we will see a massive rally in the new year?
Nobody knows, of course, but for now the selling remains relentless. If it's one thing I learned from being a technician, it's that bottoms form when markets stop going down on bad news. We are likely not there yet, judging from the past few days. But as long-term investors, we have to look past the noise and panic and rationally consider the value proposition of the stock market at today's prices. And the value proposition is that we can buy a market that is trading at a 14x-15x earnings with earnings growth probably at 5% or so and a Fed that is ready to step aside should its benign forecasts not materialize. At these levels I think we are getting fairly compensated for the risks.
That means that rather than following our primal fight-or-flight impulses and wanting to sell-sell-sell everything, we need to take a good rational look at what the market is offering vis-à-vis our investment goals, and decide accordingly in the most unemotional way possible.
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