The stock markets have given up a lot of their gains from last month as shares whipsaw between steep declines and big upswings. While the pullbacks are worrying investors, Jurrien Timmer, director of global macro for Fidelity Management and Research, says that the downturn has actually brought more balance to the markets.
"I see the market as now being in much better balance, with strong earnings growth pushing the market higher, but rising rates acting as a valuation headwind," wrote the Fidelity Investments executive in a blog post. "I believe this is still a bull market scenario, albeit a more late cycle one than before."
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Up until the recent stock market malaise, investors have enjoyed two years of strong gains with very low volatility. That came to a crashing halt during the past two weeks, with stocks selling off over concerns that the economy is growing too quickly, resulting in the likelihood that the Federal Reserve will raise interest rates more than expected. With strong corporate profits and growth in economies around the globe, many industry watchers are calling the stock market declines a pullback rather than a correction or something that will be long lasting.
The way Timmer sees it, the stock market decline was bound to happen thanks to the two imbalances in the market that have been growing since last August. One of those imbalances, wrote Timmer, was investors' lack of attention to a "sharp" rise in bond yields. The other imbalance: a "sharp" increase in earnings estimates. "The problem with that rally was that only half of it was justified, based on consensus analysis, by the earnings windfall from the tax cuts," wrote Timmer. He attributed 450 points of the rally in the S&P to tax cuts, but the price-to-earnings expansion accounted for just 250 points of the gain.
Timmer said that stock price increases due to stronger earnings growth are justified since stocks typically tend to follow earnings. The problem, however, is that valuation multiples were already elevated before tax reform kicked in. "In my view, to argue that P/E ratios should expand even further because of the tax cuts is technically correct but hard to justify given how elevated valuation levels already are," he wrote, noting that, with the other imbalance, it was simply a matter of the stock market ignoring the bond market. This is a good time to review if you can earn money in stocks.
While the two imbalances caused the sell-off in Timmer's view, he said that the problems are now mostly corrected. The market has given back the valuation boost since last August, with trailing P/E ratios now back to 20 times earnings and forward P/E ratios back around 17 times earnings. Meanwhile, the bond market now expects the Fed to raise rates four times, up from one time, during the course of the next two years.
"Whether last week's correction ended on Friday or continues for several more weeks or months to come is, of course, unknowable," said Timmer. "But the good news is that (a) bond yields are now in much better sync with the Fed, (b) the stock market has given back its (in my opinion unjustified) valuation bump from last August, and (c) it is paying attention to the bond market again (as well it should). And of course, we have (d) double-digit earnings growth."