Fall into Balance: Week of 10/7/24

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The State of the Cycle

It’s October already, and the year-to-date leaderboard looks similar to what it has been for a number of months.? Bitcoin, gold, and large cap growth stocks remain at the top, with bonds and commodities bringing up the rear.? But looks can be deceiving and there has been plenty of action below the surface.? We have had a broadening since July (initially at the expense of the headline indices, causing a 10% wobble), a large bond market rally, a flash crash of sorts in Japanese equities, and now a monster rally in Chinese stocks.

We are approaching the two-year anniversary of this cyclical bull market, which began on October 13, 2022.? Happy almost birthday!? At 24-months young and 66% strong, this bull remains modest by historical standards and suggests we are only in the 7th inning.? The chart below shows the length and strength of all bull markets over the past 100 years, with the green lines showing cyclical rallies within secular bull markets and the red lines showing rallies during secular bear markets.

Speaking of secular trends, by all measures the current secular bull market (born in 2009 by my measure) remains alive and well, although getting on in years.? The current super-cycle continues to track both the 1949-1968 and 1982-2000 cycles closely. Looks like the 8th inning or so.

In retrospect, when the current secular bull market was confirmed 11 years ago in May of 2013 (when the S&P 500 index finally took out the 2000 and 2007 highs), I could have just ignored all my other indicators and models and focused solely on this analog. It would have served me well.? The CAPE model (which states that long-term valuation ratios are predictive of forward returns) also nailed it, with the current 10-year CAGR of +13.3% coming in very close to the model’s prediction ten years ago of +14.8%. ?

In the above version of the CAPE model, I use the 5-year price/cash ratio (with cash defined as dividends plus buybacks), as opposed to the Shiller 10-year ratio. The model suggests that the market’s rate of growth will peak out in 2026 and then start to decelerate (not to negative returns but to below-average returns).

The Fed

Meanwhile, the Fed seems to have threaded the needle just right (so far), starting its cycle of policy normalization from restrictive (5.25-5.0%) eventually to neutral (3.5-4.0% by my estimates).? The rate of inflation continues to edge closer to the Fed’s target, while the labor market has worked off its pandemic-era excess labor demand.?

Friday’s employment report, following an earlier JOLTS report, shows the labor market potentially reaching a state of balance.? Now the trick is for it to stay there.? We know from history that the labor market pendulum tends to swing from one extreme to another, so for it to stop right here at the zero line would be quite an achievement.

Following the strong jobs report last week, the market has walked back its expectations of multiple jumbo rate cuts.? We are back to a more normal trajectory of 25 bps cuts and a higher terminal point (which makes sense).? As a result, rates backed up last week, with the dollar index following suit.? The dollar continues to be held captive by interest rate differentials.

Nevertheless, with the Fed cutting rates, the PBoC firing a big bazooka, and other central banks around the world also in easing mode (except for the BoJ), it’s no surprise that the global liquidity cycle is on the rise again (and with it stocks, gold, and Bitcoin).? The global money supply (as estimated by Bloomberg) is at an all-time high of $107 trillion.

Earnings

Earnings season will soon be upon us again, this time for the third quarter.? The market continues to see higher earnings, with the growth rate for 2024 and 2025 holding steady at 9.3% and 14.2%, respectively.? The dollar estimates, however, are coming down a touch, which is not unusual as the squiggles chart shows below.

However, it does appear that the rate of growth is peaking here at +12%.? In other words, earnings are growing, but they are no longer accelerating.? This indicates a maturing business cycle.

Global Rotation

With a new round of policy stimulus underway in China, questions abound whether we are finally on the cusp of a major global rotation.? We may well be, but ultimately for a period of lasting outperformance to begin for non-US equities, they will need to produce better relative earnings.? As the chart shows, relative performance follows relative earnings, regardless of relative valuation.

But valuations are stretched, which allows for the occasional snapback rally.? So far, the MSCI China index has gained 3 P/E points, which is modest by historical comparisons.? Most rallies over the past ten years produced 5 or even 10-point gains in the P/E-multiple.? So, there could be more gains to come, even if the earnings cycle does not meaningfully inflect.

But perhaps there is some potential on the earnings front.? Relative earnings between China and the US have rarely been as stretched as they are today, and the estimate progression in both absolute terms (top and middle panel) and relative terms (bottom panel) are starting to converge from extremely oversold levels.? Converging earnings plus a large valuation differential could produce more fireworks along the lines of what we have seen these past few weeks.

The Dance Between Earnings and Valuation

It's worth reviewing history in terms of what kind of conditions create mere garden variety bull or bear markets vs the occasional mega bulls and bears.? Below we see the interplay of earnings growth and changes in valuation for the S&P 500 over the years.?

Generally, these two primary components of return (with the third being dividends) are negatively correlated to each other. Price leads (anticipates) earnings, and this means that generally the market is either in P/E-expansion mode or earnings growth mode, but not both at the same time.? The pandemic recovery cycle in 2020 and the financial crisis recovery in 2009 are examples of this.

But occasionally we get a perfect storm, with both earnings and valuations either falling or rising.? The bear cycles of 2002-2002 and 2007-2009 are examples of super bears, as the above chart shows.? In both cases the market fell by more than 50%, with P/E compression compounding an earnings contraction.? We have also had periods in which both are rising, such as 1995-1998 (Greenspan rally) and 2016-2018 (Shanghai Accord).? They were both soft landing rallies, much like the current cycle.

With that in mind, let’s take a look at a few major markets around the world, to gauge this interplay between earnings and valuation.? Below is the MSCI EM index.? There’s a nascent earnings recovery underway, with the baton being passed as it typically is from valuation (purple) to earnings (blue).

And here is the MSCI EAFE index.? Same idea, although the P/E side of the equation has been more constructive.? So, for developed markets we are getting a bit of both, just like we are in the US, which is the next chart down.

Here is the MSCI China index.? So far, it’s all P/E expansion and no earnings growth.? But perhaps that could change with the current round of stimulus just getting started.

And here is that EM darling India, which is sporting both earnings growth and multiple expansion.? Much like the US, it’s this win-win combination that’s producing outsized returns.

The Role of the Payout Ratio

One important dimension of valuation is the quality of earnings.? What percentage of earnings are being returned to shareholders, and is the share count growing or shrinking?? The payout ratio is the percentage of earnings being returned via dividends and share buybacks (as well as M&A), and a high payout ratio (70%-plus) has been a persistent feature of the US stock market since the mid-2000’s.? Emerging markets, on the other hand, have produced the opposite, with companies issuing more shares than they are retiring.? For EM the payout ratio is only in the 30’s.? The chart below shows this contrast between EM (left) and the US (right).?

Shareholder dilution in emerging markets is understandable, of course, given the part of the growth curve that EM companies are on.? This is one reason why there has been a persistent gap between EM and US valuations.? For emerging markets, though, the dilution rate has been improving in recent years, so that could just justify some valuation convergence.?

In the chart below, I line up the P/E ratio (y-axis) for China, EM, EAFE, and the US against the payout ratio (x-axis).? Equity dilution and payout ratios are certainly not the only factors producing disparate valuations (sector composition and earnings growth matter as well), but the chart suggests a positive correlation between the two.?

The one major outlier is India, which has a payout ratio of only 29% (counting both equity issuance and retirements).? Yet it sports the highest P/E ratio on the planet at 25x.? This shows that dilution is only one of several factors in determining the price that investors should want to pay for a unit of earnings.

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