Bifurcated Bull: Week of 6/17/24

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Bias to Ease, Eventually

Another piece of the macro mosaic fell in place last week, with the Fed confirming the market’s recent tilt towards less easing and later.? Per the new dot plot below, the only glaring difference between the Fed and the market is where neutral is at.? The Fed still seems to think it’s around 2.5-3.0%, but the market thinks it’s 3.5-4.0%.? I will side with the market on this one (although even that number seems too low), and I suspect that the dot plot will eventually catch up.

With some clarity on the forward curve, the long end of the Treasury curve remains at fair value in the 4.0-4.5% zone (per my model, which regresses the 10-year nominal GDP growth rate and the forward curve).? If the Fed cuts to 3.5% there is some room for bonds to rally further, but if 4% is as far as the Fed goes, there is little more than coupon clipping available to bond investors.? Not that there is anything wrong with that, given that real rates are now positive.

7th Inning

For equities, this remains a tale of two markets: the mega cap growers and the rest.? While the S&P 500 cap-weighted index clocked another new all-time high last week, the equal-weighted index remains in limbo.? Only 44% of the stocks in the S&P 500 are above their 50-day moving average.?

Nevertheless, the major indices have continued to play out the soft landing thesis, with the market tracking the 1966, 1994, 1998, and 2016 cycles.

The market also continues to track the Presidential cycle, or at least that iteration in which the midterm year (2022) is down.

Bifurcated Bull

The latest new highs (at 5447) produced a number of divergences.? While tech and telecom are trading at their 100th percentile (of the 12-month range), many other sectors and groups are well shy of that.

Below we see that only large cap growth stocks are confirming the new index high.? Large value, small growth, and small value all remain at or below their 2022 highs.

Changing Narratives

The journey that the mega growers have taken is one of a series of narrative changes.? During COVID it was of course the stay-at-home narrative that propelled them higher. Made sense.? That led to a massive rotation during the reopen phase.? It made sense, but it was short lived.? Then came the Great Rate Reset of 2022, which at first punished these “long duration” stocks.? That also made sense, but it too was short lived.? Then the narrative was turned upside down, and now it was the rest of the market that fell victim to tightening financial conditions while the mega growers were a reprieve from the inverted yield curve.? That also made sense lol.? Now it’s the AI narrative that has taken over, which of course also makes sense.?

The common denominator to all these narratives is that the relative performance of the Mag 7 has been largely justified by relative earnings, although a rising valuation premium is playing a larger role now.

One way to measure the market’s breadth is to show the excess return between the Mag 7 and the S&P 500 equal-weight index (SPW).? The chart below shows that the current winning streak of the mega growers is actually not that large compared to the first half of 2023 and most of 2020.

One would think that the sector dispersion would be enormous right now, with tech and coms at the top and the rest lagging behind, but last week the difference between best and worst sector was only 9%.? The really big spikes tend to happen at bottoms, with a notable exception being the top of the dot com bubble in 2000.

Not as Expensive as it Looks

?The lopsided performance of a handful of mega-growers has thrown a monkey wrench into valuations.? The market looks expensive at 23.8x trailing earnings, and on a cap-weighted basis it is expensive.? But if we distinguish between the cap-weighted and equal-weighted indices we see that the broad market is actually not rich.? The trailing P/E ratio for the equal-weighted index is 17.8x, which is not bad at all.?

If we replace the P/E ratio with the price to free cash flow ratio, we see a similar gap.

Another way to look at this is via the discounted cash flow model (DCF).? At an implied equity risk premium (iERP) of 3.4%, the market is indeed worth that 23.8x earnings (purple).? However, if replace that 3.4% iERP with the long-term average of 5.0%, that fair value P/E drops to 16.3x (orange).? That is a big gap, explained by today’s exuberant sentiment (the ERP is after all a sentiment indicator).? But, compared to the equal-weighted P/E ratio of 17.6x (blue), the difference is not nearly as large.

One iERP measure that is not particularly useful right now is the back-of-the-envelope version that simply subtracts the 10-year yield from the earnings yield.? By that measure, the stock market is at nosebleed levels, with an iERP of close to zero (i.e., bonds and stocks offer the same yield).?

This is a bit misleading because earnings only inflected higher a few quarters ago.? Stocks are long duration assets and the above metric only covers a short window (next 12 months).? With earnings expected to grow 9% this year, 14% next year, and 11% in 2026, the market is less expensive than this metric makes it seem (even if those outer years come down, as they usually do).

Speaking of earnings, in a few weeks we will be starting another earnings season.? So far, the year-over-year estimated growth rate for Q2 earnings is 9%.? That might dip a little as we get closer to the new quarter, but given the tendency to bounce during earnings season, it’s reasonable to expect Q2 earnings to grow double digits, following an 8% growth rate in both Q1 2024 and Q4 2023.

An Opportunity Waiting for a Catalyst

Earnings drive stock prices, and relative earnings drive relative performance. That’s a good thing to remember as we continue to assess the mean-reversion opportunity between the US and ex-US.?

The chart below shows the earnings squiggles for the MSCI USA index. Up and to the right.

In contrast, this next chart shows the same squiggles for the MSCI EM index.? Earnings have not made new highs since 2010.? The bottom panel shows the squiggles relative to the US.? As you can see, those relative squiggles explain a lot of the relative performance, expressed as a 36-month Z-score of the relative return (purple bars).

Another way to visualize this stark divergence is in the chart below.? On the left is the US, where you can see a sequentially higher series of annual progressions (even if they tend to drift lower from start to finish), and on the right is the same thing for EM.? The last two decades have been one large cluster.

Relative performance follows relative earnings, as the chart below shows (top panel).? And that relative performance doesn’t seem to care about valuation.? In my view, relative valuation is a potential amplifier of a mean reversion cycle that is catalyzed by a change in earnings revisions.? That’s what I continue to wait for when it comes to this very tempting opportunity.