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 volatility just keeps on coming, with big up days followed by equally big or bigger down days. We went from several months when it was rare to see even a 1% move in the market to a stretch of several days with a daily range of 3%-plus. Overall the market is now down 10% from the September highs, entering correction territory. Welcome to October.
Slowing earnings + rising rates = Correction
The current round of volatility started with the third quarter earnings season. On the surface, earnings seem just fine. Bloomberg reports that with 240 companies reporting, 83% are beating earnings estimates and 58% are beating their topline estimates. The year-over-year growth rate is now up to 23.2%, up from 19.5% at the start of earnings season. This is very much in line with Q1 and Q2.
But the gains are coming at the expense of Q4 estimates and beyond, with the Q4 estimate falling from 19.5% to 16.9% in recent weeks. The estimates for Q1 and Q2 2019 are also falling slightly to around 7%.
In other words, the growth peak seems to be in. That really shouldn’t come as a surprise to anyone, since 24% growth is unsustainable. The bigger question is where the earnings growth rate is heading in 2019 and beyond. The street has been at 11% for 2019 and 10% for 2020, but we’ll see.
At the same time, the cost of capital has been rising as liquidity conditions have been growing more restrictive. In fact, rates had risen sharply from August through a few days ago, as the US Federal Reserve has been guiding the bond market to a steeper and perhaps longer path of rate hikes, aiming to reach the 3.0%–3.5% zone for the federal funds target rate in 2020. Things have settled down for the bond market in recent weeks, however, in response to the stock market sell-off.
The market math
I like to look at what I call the market math: where stock prices are a reflection of earnings growth and liquidity conditions. When earnings (E) are growing and liquidity conditions (r) are accommodative, valuations (P/E ratios) go up. When the price-earnings (P/E) ratio rises along with earnings, then by definition stock prices go up even more than earnings. That’s your roaring bull market "Goldilocks" scenario. The worst-case scenario is that the E goes down and liquidity conditions are tight, driving the P/E down. A falling P/E, plus falling earnings means that price goes down a lot.
Where are we now? Somewhere in the middle. Earnings are booming but peaking, and liquidity conditions are tightening, as the Fed normalizes policy by raising rates and shrinking its balance sheet. That spells P/E compression, which is exactly what is happening—there seems to be a consensus that the Goldilocks phase is over.
The good news is that, as of Friday, the 12-month forward P/E ratio (based on 12 month earnings estimates) is down to 15.3x for the S&P 500. That's more than four points below the January high, or a 20% drop. That means that we are getting a 20% valuation haircut with only a 10% drawdown in price. I still think that's a win, at least compared to the alternative.
As of Friday the S&P 500 is down 10.6% from its intraday day high of 2940, set only a few weeks ago, to last week’s low of 2628. You may remember that back in January-February the market was down 11.8% peak-to-trough. So, we now have two 10% drawdowns in the span of 9 months or so.
This very much reminds me of the period from late 2014 to early 2016, when the SPX had 2 drawdowns of 10%-15% within the context of a sideways range, while emerging market stocks were getting hammered and the Fed was trying to start its tightening phase. Sound familiar? The other analog is of course 1994, another year-long period of sideways with 2 10% drawdowns while the Fed was tightening and emerging markets were in trouble.
What will happen next?
It's impossible to predict short-term market moves, but I do not think that this is a bear market. Earnings would likely have to fall outright and liquidity would have to get tighter than the Fed is currently signaling for the market to decline 20%, and we don’t have those conditions. With a P/E ratio at 15X, this is no longer an expensive market. But I don't think the market is about to rocket higher. We remain very much in a market purgatory, in between bull and bear. I think it makes sense to lower expectations until there is more clarity about the end of the rate hike cycle. As the market goes sideways and earnings grow, valuations are coming down. Maybe we go into next year at 15X earnings at 10% earnings growth, and that could be a good backdrop for the stock market.
For a buy and hold investor, if you are following a plan based on your goals, financial situation, timeline and risk tolerance, you may not want to do anything. If you have a plan but are not allocated according to plan, you should sit down with your advisor and see where you need to be. It may be time to rebalance.
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