Foundational Questions (Part 1): Week of 5/28/24

This information is provided for educational purposes only and is not a recommendation or an offer or solicitation to buy or sell any security or for any investment advisory service. The views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Opinions discussed are those of the individual contributor, are subject to change, and do not necessarily represent the views of Fidelity. Fidelity does not assume any duty to update any of the information.

The State of the Cyclical Bull Market

In addition to giving thanks to all those who have served, this cloudy and cool Memorial Day has been a good opportunity to dig into the chart archives (good thing I got my rides in earlier this weekend).?

My thesis remains that we are in a 7&7 market, i.e., the 7th inning of a cyclical bull market within the 7th inning of a secular bull market.? While the foundation remains solid, valuations are high and the inflation question looms large.? Inflation is the slayer of high valuations, and in an era of fiscal dominance we can’t afford to be complacent.

On the surface we seem to be only in the 5th inning of this cyclical bull market, given that the median duration and magnitude are 30 months and 90%. ?So far, we are at 20 months and 50%. ?However, when we consider those historical boom-bust cycles during which inflation was elevated, those bull markets were often shorter and shallower.? Hence my guess that we are further along in this cycle.

Election Dynamics

We are in year 4 of the Presidential cycle, and that year tends to be strong, especially when it follows a down mid-term year.? The market has closely followed this “down mid-term” cycle.

While a strong economy and stock market might seem to favor the incumbent party (per the chart below), the polls indicate a very close race.

There are surely numerous reasons for this, but inflation seems to be a big factor.? Consumer confidence surveys indicate that many Americans are not content with their economic condition, despite a 3.9% jobless rate.?

Fiscal Dominance

Part of the inflation and economic story is undoubtedly the fiscal backdrop.? The government continues to spend 6% more than it takes in, despite an economy that is running on all cylinders.? With entitlements, defense, and debt service comprising most of the spending, there seems to be no end in sight in terms of deficits.? And as the chart shows below, deficit spending seems to be a bipartisan endeavor these days.

Unless the US can grow itself out of a debt spiral (as it did following WWII), we seem to have entered a period of unsustainable fiscal dominance.? This is especially the case now that the Fed and other central banks (namely Japan and China) are no longer buying Treasuries.? Without growth or austerity, inflation and monetary debasement may be our new reaility.

Perhaps policy makers (including the Fed) will devise a way to regulate the banks into buying Treasuries market (much like they did during the 1940’s).? Either way, it seems to me that the Fed will have to a role to play in keeping bond yields at bay.

?

Bias to Ease, but When (and How Much)?

For now, the bond market doesn’t seem too worried about a fiscal doom loop, and as of last week the term premium remains slightly negative.? As for the Fed, with growth moderating and the inflation rate in the 3-4% range, there is some room for the Fed to give back a few of its many rate hikes.? Different versions of the Taylor Rule are moderating (per the chart below), so it may just be a question of how many rate cuts and when.

The forward curve is now pricing in the first rate cut by the end of the year, which makes sense to me.? With a natural real rate around 1% and inflation at 3.5%, a neutral policy would appear to be around 4-5%, with room to fall to 4% or lower if inflation moderates further into the 2-3% zone.

The risk to that benign outcome is a stagflation cycle, in which growth slows and inflation remains elevated.? Indeed, the latest purchasing managers index (PMI) shows exactly that.? The Fed has a dual mandate of price stability and full employment, and a stagflation cycle would be put those two mandates squarely at odds with each other.

But for now, cyclically speaking, growing earnings and a moderating Fed appear to have the upper end against high valuations and sticky inflation.? Seventh inning.?

?

The State of the Secular Bull Market

In terms of the secular trend, I think we are also in the 7th inning.? Secular bull markets are prolonged super-cycles spanning a decade or more and producing above-trend returns.? In my view we have been in a secular bull market since 2009, not unlike the 1949-1968 and 1982-2000 regimes.? Below we see how closely the current super-cycle has tracked those two.? There was also the 1920-1929 secular bull market, but it went too far too fast, and like Icarus it got its wings burned prematurely.

The price analog only gets us so far, so we need to look at valuations.? My favorite valuation metric is the 5-year price to total cash ratio.? Total cash includes dividends and share buybacks.? The latter adds an important dimension to today’s valuation picture that the 10-year Shiller P/E ratio does not.? It’s all about the payout ratio, and if share buybacks are a form of dividend, it means that investors are getting more of their earnings back, which commands a higher valuation multiple.? Compared to past secular regimes, on a price to cash basis the current secular bull does not appear to be over its skis yet.

Having said that, we do know that valuations are historically high.? While valuations are useless in predicting short-term returns, they have been effective in predicting long-term returns.? We can see a clear inverse correlation between the trailing 5-year price to cash ratio (as well as the Shiller CAPE) and the forward 10-year CAGR.

Below is the same relationship expressed as a time series.? High current valuations beget lower future returns, and the price to cash ratio suggests that the market’s 10-year CAGR peaked in 2021 at 16.5% and is on its way to a 7% CAGR over the next decade.? That would not be the end of the world, but it is less than the historical average of 11%, and consistent with the idea that the secular bull market is aging.

Looking at this another way, we can create a return projection based on the CAPE model.? It’s a simple matter of regressing the valuation ratio against the forward return, and applying that fitted forward return to the S&P 500 ten years ago.? That’s the orange line below.? You have to squint to see it, but the trendlines of the S&P 500 index and its projected level are nearly identical.

Given that we are converting a 10-year CAGR into an index, the line is much smoother than would ever happen in real time.?? But the point here is to identify secular regimes of above-trend returns vs below-trend returns.? That’s shown in the lower panel.? Above-trend means the fitted line is converging towards the trendline from below that trendline, and below average means it is converging lower from above the trendline.?

According to the above, the current bullish convergence will reach a secular peak sometime in 2026, putting us in the 7th inning of this secular bull market.? It’s important to note that a peak in 2026 does not mean that the market will go down after that, only that the 10-year return will go from above-average to below-average.? Below average can still be a rising market (just less than 11%), and indeed that’s what this version of the CAPE model suggests.?

Of course, all this assumes that the market follows a rational valuation roadmap.? You can see in the chart above that during the late 1990’s the market went to irrational levels, and it took a “lost decade” for stocks to finally become fairly valued again.? Therefore, I would not set my watch too closely to this roadmap, but instead use it as a rough guide for strategic allocation.?

More on the secular regime and its implications for our portfolios in part 2 next week.