Different Paths Leading to the Same Place: Week of 11/04/24

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Greetings from Holland, where I spent the weekend with my parents before flying to Madrid and Milan for a client roadshow.? At 90 and 96 (and about to turn 97), mom and dad are both doing well, and my mom even let me into her kitchen to make dinner (an honor bestowed on very few, if anyone). ?A health scare a year ago was another reminder of life’s impermanence, and I take every opportunity to see them (which is challenging since we live on opposite sides of the Atlantic).? I have a few rituals when I visit them in The Hague, including going to the local supermarket, long walks through the dunes (the photo above is of the “zandmonster” in Kijkduin), and of course getting a “broodje kroket.”? I left them with a grateful heart, rested body, and a full belly, and look forward to the next visit.?

What Time is it?

If the market cycle was a clock, with 12 o’clock being the median length of a cyclical bull market, we are now at 10 o’clock.? We seem to be in the 7th or 8th inning, with the only question being whether we are going to extra innings or even a double header.

After a slow start, at 25 months old this cyclical bull is now right on track with regards to the historic average.

Tailwinds

Equities have benefited from twin tailwinds in the form of simultaneously expanding valuations and growing earnings. In the chart below, the purple bars show the year-over-year change in the trailing P/E-ratio and the blue bars show the growth rate in trailing earnings.

This one-two punch of earnings and valuation is somewhat unusual, since the multiple-expansion phase typically ends after a year of the start of a bull market, with earnings doing the heavy lifting after that.? In the chart below, the orange dotted line is the average P/E-expansion measured from the start of a new cycle and the solid line is the current cycle.? Earnings are doing the work, but valuations are helping a lot.

Technicals

Technically, the uptrend remains intact, and both the S&P 500 cap-weighted and equal-weighted indices have continued on their journey of making higher highs and higher lows.

However, there has been some loss of breadth and momentum in recent days, and as of Friday only half of the stocks in the index were trading above their 50-day moving average.

Earnings

While earnings continue to grow, with Q3 earnings season so far producing the standard bounce, we seem to be reaching an inflection point in the second derivative (earnings growth).?

With 352 companies reporting so far, 76% are beating estimates by around 668 bps, pushing the Q3 EPS number higher by $2.3 so far.? This is in line with the typical bounce.

The calendar year estimates have been holding steady, but the 2024 and 2025 estimates are no longer advancing as they were earlier this year. It suggests a maturing cycle.

Valuation

On the valuation side, things are getting closer to the extremes set in 2021.? While the equal-weighted S&P 500 trades only at 19x earnings and the Russell 2000 trades at 17x, the cap-weighted index is approaching more lofty levels.

While high valuations can be partially forgiven due to the full rebound in operating margins (per the chart below), a 25x trailing P/E ratio is a high hurdle to clear when the growth rate is peaking and P/E multiples have already expanded 36% during this cycle.?

In my view, it’s going to be difficult for this cyclical bull to continue on its current torrid path.? Later innings suggests a lower slope for this cycle.

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Fiscal Dominance & Rate Tantrums

If there is one thesis that I have high conviction in for the coming years, is that the US is on a path towards fiscal dominance.? With the Fed and other central banks no longer the buyer of first and last resort, it seems plausible that the term premium might rise in the months and years ahead.?

If you are skeptical of that view, take a look at the chart below and tell me what compensation investors might demand to fill the $10 trillion gap between the federal debt and the Fed’s balance sheet.? As of last week, the term premium was 22 bps.? It’s higher than it has been, but it still seems low to me.

Rising term premia mean rising real yields.? In a regime of positive correlations (between stocks and bonds), rising rates can cause wobbles in the stock market.?

We saw this in 2022 and one year ago in October 2023 (when the 10-year pushed against 5%), and again several times this year.? Rate tantrums may not necessarily end equity bull markets, but they can sure put a dent in the bullish momentum (as we saw again last week).

A rising term premium could offset the otherwise bullish implications for bonds stemming from the expected path of rate cuts from the Fed.? My bond model (below) regresses the forward curve and GDP growth to estimate the fair value for bonds.? It has been indicating that 3.6% is roughly fair value, based mostly on the expected path of Fed rate cuts (to 3.6%).?

However, this model assumes that the current term premium is “correct,” much like the discounted cash flow model (DCF) assumes that the implied equity risk premium (iERP) is correct in computing the fair value for stocks.? Risk premia are really sentiment indicators, and they can flip on a dime.

If in the model above we add a gradual expansion in the term premium from the current 22 bps to a historically more typical 125 bps, we get what is in my opinion a more plausible path forward.? High 4’s with an occasional flare-up to a 5-handle.

Rate cuts have dominated bond yields so far during this cycle, but going forward the term premium may well trump the Fed cycle (no pun intended).?The Fed model has returned and is likely here to stay.

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