Markets Driven by Multiple Expansion Have Been Durable

Overall, 2024’s returns were primarily driven by multiple expansion, not earnings growth. Rolling Q3 data from S&P illustrates the point most dramatically. At that time in Q3, 75% of the 30+ percent return in the market was driven by multiples. To be fair, the year-on-year returns have come down, and earnings growth for the final year is a bit higher, but you see the point: For much of the year, 2024’s gains didn’t look “justified” by its earnings growth. It was a top quartile dislocation, with data back to the 1930s.

This brings up the historical question – is this a problem for markets? The answer is an ironic no. The years following returns driven disproportionately by multiple expansion are historically better markets, producing almost double the average returns of fundamentally driven markets. Importantly, markets that start out expensive (like ours) have been 5x as good as fundamentally driven markets, most often continuing to provide above average returns.

Not only have the average returns been better, but there has been a relationship historically - the more the market has been driven by multiple expansion (versus earnings growth), the better the forward returns were likely to be. As usual, history illustrates that your first guess at meaning - Returns not supported by fundamentals are likely at risk - might be the least likely outcome.

Although it often seems that little in the markets makes sense, it often later turns out to make perfect sense. Multiple driven markets, when starting points are expensive, historically produce 50% better earnings growth over the next 3 years. If we think of 3 years as a proxy for mid-cycle or normalized earnings, it turns out mid-cycle earnings is higher than you thought. This means that stocks weren’t as expensive as you thought. And the market – via multiple expansion – figured it out first. Seller beware.

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.