Equity markets posted higher returns (+0.7%) for the eighth time in the past ten weeks while bond markets traded flat last week. Investors have now pushed the S&P 500 up +27% from the October 2022 lows and within striking distance of the all-time highs, whereas fixed income markets sit more than -12% below their all-time highs as measured by the Bloomberg US Aggregate index. In a somewhat data-lite week, markets remained focused on corporate earnings and the health of the US consumer ahead of the next Federal Reserve rate announcement/press conference on Wednesday.
Almost $10 trillion has been restored to equity values in the past nine months as cooling inflation, robust job growth, resilient consumer spending, and now, better-than-feared corporate earnings have defied economist and analyst expectations. Some forecasters who were quick to predict a US recession and a benign equity market recovery are beginning to reverse course and hedge their bets. Simply put, nearly all forecasters misjudged the push/pull of robust economic data against the backdrop of higher inflation, tighter monetary policy, and calls for recession. The market has blown past most economist estimates and data from Bloomberg now shows only 6 out of 25 economists show price targets higher than the current levels (and many of those have been recently revised to reflect the 2023 market rally). Going forward, economists and forecasters have a dilemma… Do they choose to keep their revisions lower than current levels and expect a reversal in 2H 2023? Or lean into the rally and push their forecasts higher? Time will tell, but many indicators suggest that this rally will need more fundamental support before moving meaningfully higher.
Less than 20 months after the bear market began in earnest, the S&P 500 sits just 3% below the all-time highs on a total return basis and less than 5.5% below based on price. While the market has been in recovery mode (dare we say a new bull market?), the volatility index (VIX) has been suppressed, barely breaking above 15, and the S&P has not registered a down day more than -1% since May 23rd.
As we briefly discussed at the end of Q2, the driving force behind the market rally has been valuation expansion particularly with the largest companies in the index. To expand on that, the next charts show that the top names in the index are skewing the entire market; however, the remaining companies in the S&P 500 are still overvalued relative to history based on PE ratios. Nevertheless, as the top names make new all-time highs, there is still some room for the rest of the market to catch up (or for the top 10 names to correct and trade lower).
Valuations are historically a bad predictor of short-term returns, especially in momentum driven markets, but they usually have forecasting accuracy on a long-term basis. Amid high valuations, investors may be asking, “Is there any bad news is priced into market?” At the moment, the answer would suggest very little. Cyclical stocks are participating in the rally, credit spreads are near their recent lows, consumer spending remains steady, and even real-time GDP growth expectations are creeping higher. The only areas that may suggest weakness come from lower corporate earnings/margin expectations and suppressed consumer and investor sentiment, although these seem to be stabilizing as well. It seems the Fed has engineered a higher probability of the fabled “soft landing”, but the US economy is not out of the woods yet.
The chart below shows valuation in rank order based on Z-score (or standard deviations from the mean) across several metrics and different asset classes. On the right side of the chart are the most overvalued areas of the market – US growth, US large cap, and US high yield – compared to Treasuries and US core fixed income on the undervalued (left) side of the chart.
The chart below from Fidelity shows that many economies face headwinds related to late economic cycles – growth moderating, tightening credit conditions, persistent inflationary pressures, and growing inventories – but the global cycle is not overly synchronized. China’s economy continues to benefit from the post-COVID reopening although the effects of fiscal stimulus remain unknown. Europe has seemingly stabilized amid falling energy prices and the US appears to be in the late-cycle expansion phase with solid near-term momentum. Late cycles can persist for a very long time and the best performing equity factors during these periods are typically profitability, quality, and low volatility. For fixed income investors, investment grade and government issues tend to offer the best value in late expansionary periods as interest rates moderate and risk builds in the system.
Source: Bloomberg, YCharts, JPMorgan, Fidelity