The Big Picture
The election is going to dominate the media's attention in the coming week and rightfully so. Following close behind -- for the business media anyway -- will be the FOMC meeting.
One outcome is all but assured. The other is not. The FOMC is widely expected to cut the target range for the fed funds rate on November 7 by another 25 basis points to 4.50-4.75%.
The stock market has been fortified by the thought that the Fed will be cutting rates, but it hasn't been fortified by just that. It has also been fortified by the sight of rising earnings estimates, which have kept it levitated with a premium valuation.
There has been a subtle, and not-so-subtle, change of late, however, that could weaken the bull market edifice if things persist.
The Subtle Change
The forward 12-month earnings estimate has moved from $265.36 at the end of August to $267.83 today, according to FactSet. That is a good thing. Rising earnings estimates are good, especially the forward 12-month estimate that market participants tend to favor.
Over the same period, however, the calendar year 2025 (CY25) earnings estimate has dropped from $277.74 to $273.67. That is not so good. Granted the CY25 EPS estimate is higher than the forward 12-month estimate, yet it is the trend that is noteworthy considering we are two months away from the CY25 effectively being the forward 12-month estimate.
At the current CY25 estimate, the S&P 500 trades at 21.0x earnings, which leaves it trading "cheaper" relative to the 21.5x forward 12-month multiple. That discount gives this bull market a little more room to maneuver, because if it can hold up at 21.5x forward 12-month estimates, why not 21.5x CY25 estimates?
With the S&P 500 at 5,753, a 21.5x CY25 multiple takes it to 5,883. If we press things and take it to the 22x forward 12-month multiple the S&P 500 sported in mid-October, then we get to 6,020 -- but that is if the CY25 earnings estimate remains static.
It won't. The estimate will change, and how it changes will matter in terms of where this market will allow itself to go. A market can remain overvalued if the earnings estimate trend is on its side, but if that trend turns against it, then the willingness to pay a premium for every dollar of earnings will turn against the market too.
That could mean anything from a market that stays range-bound to a market that suffers a correction (generally defined as a 10% pullback from a high) or -- gasp -- a bear market (generally defined as a 20%+ pullback from a high).
Where things fall on that continuum would have a lot to do with how far earnings estimates fall. This why economic data is being watched so closely. If the economy deteriorates, earnings estimates will come down, but if the economy holds up like it has been holding up, the risk of a material downward revision is lessened.
That is where things stand today. The stock market is holding up with a premium valuation because the economy and earnings are holding up. Accordingly, the subtle change in the CY25 earnings estimate hasn't registered as a scare factor.
Something else, though, that is beginning to spook the stock market a bit is the trend in market rates.
The Not-So-Subtle Change
It isn't a mystery to anyone following the market that Treasury yields have risen after the Fed cut rates on September 18. The mystery to many in the market is why that has been the case. There isn't a pinpoint explanation, yet there is a lot of chatter about the following influences:
- Pricing out a hard landing scenario (i.e., no recession) and possibly even pricing out a soft landing scenario (i.e., economy just keeps growing above potential)
- Worries about inflation heating up again because the economy is remaining strong, yet the Fed is cutting rates
- Increased angst about the surging budget deficit and national debt, both of which are projected to worsen no matter who wins the presidential vote
- Some unwinding of the safety trade revolving around geopolitics after Israel tempered its response and held off attacking Iran's oil/nuclear facilities
- Asset reallocation out of bonds and into stocks (for many of the reasons cited here)
- Technical selling after the 10-yr note cleared resistance at its 200-day moving average at 4.18%
- Recalibrating the number of rate cuts the Fed might enact
The cumulative effect of the matter is that the 2-yr note yield has risen 60 basis points to 4.21% since September 17 (the day before the 50-basis points rate cut) while the 10-yr note yield has risen 73 basis points to 4.37%.
With this move in rates, it has also been said that the stock market can handle it given that it did fine when rates were even higher. This is true, although the valuation wasn't quite as demanding as it is today when the 10-yr note yield traded north of 4.50%. In any case, the chart below shows that there was multiple compression the past few years when the 10-yr note yield got above 4.50%.
One of the other key points as to why the stock market held its own when rates were higher is that earnings estimates were still trending higher; hence, the pullbacks were seen as buying opportunities rooted in what was still a fundamentally sound backdrop.
What It All Means
The stock market has maintained a resilient disposition, beating back selling interest and sticking near record highs. It has struggled more recently, though, to take another leg higher.
That struggle has to do in part with the uncertainty regarding the outcome of the election, yet some fundamental factors are rounding into form as an impediment. There is the subtle factor of CY25 earnings estimates coming down and the not-so-subtle factor of market rates moving up appreciably -- and quickly -- since the Fed cut rates on September 18 and the presidential candidates got more vocal about their policy proposals.
Higher interest rates can be tolerated to a point, but if market rates continue to ratchet up, and earnings estimates don't, the multiple expansion that has been a hallmark of this bull market is apt to give way to multiple compression that may or may not be subtle depending on the driver.
