FidelityConnects: Denise Chisholm – Sector watch – October 23, 2025

[00:01:53] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. Valuations may shape expectations but they don't determine destiny. Our next guest challenges the idea that CAPE, or the cyclically adjusted price to earnings ratio, can predict returns on its own. She notes that CAPE's predictive power weakens once you strip out crisis periods. That's not just where the markets start but also how they end, and that's what often can really move the needle. Joining us here today to separate valuation myths from market reality is Fidelity Director of Quantitative Market Strategy, Denise Chisholm. Welcome, Denise, great to see you.

[00:02:33] Denise Chisholm: Hi, Pamela. It's great to be back.

[00:02:35] Pamela Ritchie: Delighted to have you join us here today. We'll invite everyone to send their questions in for the next half hour or so. Denise, you actually often say and tell us that starting points matter. Whatever has gone up for a long, long time perhaps isn't the best sector to rotate into at a certain point. We're going to talk about the ending points. Why is that?

[00:02:56] Denise Chisholm: The ending points are, for when we think about valuation, often more important than the starting point on valuation. That's true for sectors as well but it's even more true for the market. If you back up, much ink has been spilled on the topic of valuations. I think everybody's heard me talk about the quantitative myths associated with it, which you highlighted. It's interesting, there are many times in the market when the market's expensive but more expensive than it appears because earnings is actually overestimated. Earnings being the key trend, or sometimes in the market when the market is top quartile expensive, when earnings growth is still strong and the market appears to be more expensive than it actually is. So many of these variables like earnings drive the ending point so much more such that when you look back in the data for any one given year whatever quartile you're in in terms of valuations from the cheapest quartile to the most expensive quartile, your go-forward odds of a market advance are the same in each of those valuation metrics, 75%.

[00:04:00] Again, back to your myth versus reality, I'm not saying that there's no information content in there but there are other more important variables that actually drive the outcome. In theory you would say, well, that makes sense for any given year because really that's not a full cycle, but something that encompasses a full cycle, like a 10-year period, where you cyclically adjust the earnings and normalize them, surely that is predictive.

[00:04:46] The interesting part, which you actually highlight, is one of those situations probably a lot of us listening to this call lived through. Your starting point was the dot-com bubble and your ending point was the financial crisis. For me, okay, well we have two things going on at once which is actually more important, the starting point or the crisis ending point? There are a bunch of different ways that you can test that, one of which is just strip out the GFC. Yes, that strips out a starting point as well but we've got a lot of data, we're going back to 1930. Once you strip that out R squared falls to .4%, your explanatory power drops by 25% and now all of a sudden your single variable of valuation explains less than half of the variation in returns.

[00:05:34] Said differently, if you actually juxtapose all this and say, well, wait a minute, if my starting point on valuation is expensive but I don't end in a crisis, if we look back and call the very ... look, it's a complete hindsight exercise. Let's just call World War II a big crisis, let's call the recessions in the '70s and '80s a big crisis, so '75, '80 and '82, those were inflationary crises, and let's call the financial crisis a big crisis. Every other recession let's call just a garden variety recession, so not every recession going back, we just say those crises, and you didn't end with that regardless of where you started from a valuation perspective, what were your returns? That's a lot of math that I just threw at you but it sort of highlights the fact that ending points actually matter a whole lot more than starting points on valuation.

[00:06:46] Pamela Ritchie: Also, the false ending points or the false crisis endings that we often think that we're heading towards. I mean, it's why there's a wall of worry and why you think, oh gosh, this is the next big bump in the night around the corner and perhaps people sell out of the markets. You're pointing out that one, they don't happen very often and two, a lot of people sort of expect them more often, I guess, than they come and make decisions based on them.

[00:07:11] Denise Chisholm: That's exactly right. The question becomes is there this correlation that I'm sort of teasing out in the math, where it looks some starting points have been correlated with crisis ending points, but if you tease out that correlation how common are these crisis ending points, it actually only happens 17% of the years from 1930? I mean, remember [crosstalk].

[00:07:31] Pamela Ritchie: Seventeen, one seven?

[00:07:31] Denise Chisholm: One seven, 17%, which is not to say that they don't happen. Of course, they happen. I think it's really important to understand that there's a correlation and not clearly a causation. If you're using valuation as your decision in terms of whether or not to be overweight equities in your portfolio for the next 10 years you should understand that mathematically you're intrinsically betting on a crisis ending, not just a recession, but a crisis-ending 10 years out. If you don't bet on that then you don't get below average returns. Your average returns are 10 percentage points. [crosstalk]

[00:08:10] Pamela Ritchie: Because the markets go up. I mean, the markets just continue.

[00:08:12] Denise Chisholm: Valuation is sometimes justified. Earnings growth is more important than valuation. I think that the interesting part is two things are true at the same time, meaning all else equal we would rather stocks be cheaper on a cyclically adjusted P/E/ basis so if you end in crisis, if you end in crisis and your starting point is expensive you get three percentage points of returns annually over that 10-year period. If your starting point is cheap you get five percentage points. Both are below average but it cushions you by about 2% on that downside. Now, conversely, on the upside if you say, okay, there's no crisis 10 years out, my starting point is cheap, 14 percentage points of returns, CAGR, over that next 10 years. If my starting point is expensive, 10 percentage points. Both are above average, average is 8, but you get more from valuation when your starting point is cheap.

[00:09:08] It's true that all else equal valuation cushions your downside and bolsters your upside. That said, if you use that starting point to use that as your methodology for underweighting or overweighting equities I think you're intrinsically not understanding that you're betting on a crisis ending. Again, two things can be true at the same time. Valuation can improve your risk-reward but it can't make your decision for you in terms of buy or sell.

[00:09:35] Pamela Ritchie: First of all, is crisis ending yours? Did you make it up? Is that someone else's term?

[00:09:40] Denise Chisholm: Those are my made up terms.

[00:09:43] Pamela Ritchie: Just take us back through ... you mentioned the actual crises where markets ... it was an absolute bottom that you wanted to not be part of. World War II, then you had through the '70s and '80s, and what else?

[00:09:56] Denise Chisholm: The great inflation.

[00:09:57] Pamela Ritchie: The great inflation, okay. We typically look at the dot-com through to the great financial crisis and kind of only that.

[00:10:05] Denise Chisholm: Right. The more you shorten your time horizon the less predictive power it has when you strip out crises. In some ways that's the interesting part when you sort of study history, again, we're sort of stripping out just three eras, which is the financial crisis, well, the great financial crisis, the great inflation crisis and in some ways one of the great world wars. Other than those three we've had a lot of other recessions. We had two recessions I think in the '50s, we had a recession in 1960, we had a recession in 1970, we had a recession in 990, we had 9/11, we the COVID pandemic, we have had a of things that if you started and said, hey, this is what's gonna end up happening 10 years out, you might say that COVID would be a crisis ending recession that would diminish your 10-year returns and yet you would be wrong.

[00:10:52] Which is not to say that Denise Chisholm has perfect foresight and knows whether or not we will end in crisis in 10 years but it is to say that I think a lot of the things that we think would be crisis endings were not. It takes something more than what you normally think of that ends in a recession to be recession ending. Said differently, the whole thing, I think that equities ... so many times I get investors struggling with the sense that, well, times need to be good to buy equities. When we look over the last five years, and I always quote the time in the '70s and '80s where sometimes equities go up during very bad times as well, which to me, if you just sort of drop a quant in the history and analyze it you go, are you sure it's not a reflection of good times or a hedge for bad times? I think that that's the struggle that ... again, I don't have all of the answers but I think sometimes history can show you what you're betting on so at least you understand. The valuations in and of themselves are not predictive for lower returns. To your point, it's not destiny.

[00:11:55] Pamela Ritchie: It's not destiny. It's your point. It's in your great slide, actually, that people can look up on LinkedIn. So all this worry, let me just ask you this to push back on the way the economy, for instance, in COVID, was rescued which was governments just dumping money into the economies, essentially, through lots of different levers and measures and so on. Would governments do that again? My point is, would it be an elongated crisis at this point because we sort of learned the lessons of floating money and helicopter money.

[00:12:28] Denise Chisholm: It certainly may be. That would be sort of the bear argument in terms of, well, there is no more left government funding to fund. I will say  from a differentiated perspective there is many more Fed cuts that can be in the pipeline relative to history as well. Maybe, being open-minded, there is a trade-off between what becomes fiscal accommodation versus what can become monetary accommodation. There's also the data point that it's not very clear to me when I look through history, I mean, ex the 2020 pandemic issue, how effective either fiscal stimulus or monetary stimulus really are relative to the creative destruction that usually happens in recessions, meaning that I think sometimes when you look through history, certainly we saw this in the recession in 1970, governments tend to throw a lot of money at or near the bottom of the cycle when, in fact, you're already starting to see the uptrend in corporate America.

[00:13:25] It's a debate on how effective these stimulus measures really are. Again, I think that there are things that we don't really know in the data so even if we don't have the same type of fiscal stimulus, that's sometimes been true in the past, it's a little bit of a trade for more monetary stimulus than we've seen in essentially 15 to 20 years which, actually, may or may not be more effective, or maybe at the same time sometimes or sessions just entail creative destruction, the economy ends up writing itself despite either the stimulus or the contractions in either fiscal or monetary.

[00:14:02] Pamela Ritchie: There's been headline noise which I end up reading so I'll put it to you to clear our minds so we know what we're actually dealing with. The term momentum, which is a factor, has been thrown around as if it's sort of getting a bit crushed here and there. When we entered this year lots of people would say momentum was the factor most at risk just because it had done so, so well. It came back, it's done very well. This year a couple of different points as well. Now you hear value a lot. You have some discussions about the international trade potentially being a value trap. I mean, the whole impetus has been a U.S. dollar, certain types of policy changes, obviously, in the U.S., but also that there has been value around the world to buy up. What do you think about that right now? Take us through some of your thoughts and some of the charts that you have to address this.

[00:14:58] Denise Chisholm: Obviously, we've seen a sharp rotation, certainly, year-to-date but I think, certainly, in the peak of the trade war in April you saw a sharp rotation into international equities out of U.S. equities. The question is, is this the start of a new trend or is this just yet another bounce in a sustained underperformance trend that we've seen outside the United States. I lean towards the latter. The reason I lean towards the latter is because when you look at valuation in and of itself that tends to not be predictive of future returns for international equities. Why? Because it's usually correlated to the fact that over time cycle to cycle international equites grow less fast than U.S. companies, meaning they're less profitable. They are less profitable therefore they deserve, from a mathematical perspective, a lower multiple.

[00:15:49] The argument this time would be, well, it's different this time because now we are starting to finally see green shoots out of Europe in terms of spending so they're not quite as constrained on a fiscal perspective. What I'm seeing in the earnings data is that you saw a little of that when earnings were decelerating in the U.S. and they were accelerating in Europe, and it was, I think, a correlation at the same time that international saw outperformance but you're already seeing that change, meaning that we're seeing international ex the U.S. whether you look at EAFE, whether you look at Europe, whether you look at EM, earnings growth is decelerating at the exact same time that earnings growth in the U.S. is picking up again and reaccelerating. And we are getting more diffusion that we talked about in terms of median earnings growth.

[00:16:35] That growth divide, for as much as we want to say, oh, it seems like it's going to be different this time, I'm not seeing it in the data which means that valuation is likely not predictive if I lean on history, which means that international screens like a value trap. When you look at the math if you say, hey, these stocks are still cheap and they worked, that's actually, historically, the worst spot to own international equities. Valuation, back to what does it really mean, it's usually right. If stocks are cheap they're cheap for a reason. If stocks are expensive they're expensive for a reason.

[00:17:20] You see this odd corollary and I think that you're seeing it play out. Where you've had this outperformance the stocks are still cheap, that seems like on the surface, well, that would be a good time to invest. I think it ends up being one of the worst situations historically because low valuations are getting the downtrend right in earnings growth. Yes, everything is growing faster than it was over the course of the globe but U.S. earnings growth is now reaccelerating which means that those valuations are justified and it could mean that we see the resumption of the downtrend outside the U.S.

[00:17:54] Pamela Ritchie: That's fascinating. Take that internally to the U.S. where we're taking a look at sort of the rest of it, the equal-weighted story, whether you want to look at other areas of the U.S. stock markets which have not flown along with expensive stocks that, as you say, perhaps deserve their valuations. They're highly profitable companies. What about the everything else within the U.S.?

[00:18:19] Denise Chisholm: Everything else within the U.S. is finally starting to look interesting from an earnings perspective. That is, I think, one of the things that gives me confidence in the outlook in that we are finally starting to see an inflection in median earnings growth. This has been the longest cycle on record where we've seen cap-weighted earnings growth grow above 5% and median earnings growth still be in a contractionary phase, or in an earnings recession, despite the fact that we're not in a recession. It's twice as long as the historical average and we are now just emerging from that earnings growth. We now finally have diffusion among companies being profitable and that usually gives a nod to the durability of that earnings growth.

[00:19:02] Again, this is critical, right? If you're saying that stocks being expensive usually predicts future earnings growth so it all ends up being okay, Denise, this is critical. This is the ultimate driver. A lot of what I'm seeing in terms of that ultimate driver is mathematically very cohesive. The longer that we've seen in terms of an earnings recession, and on a median basis ours has been as long, not magnitude but on a time basis, has been long as the great financial crisis, as long as the dot-com bubble. This is really a good setup because the longer the earnings recession has been the more durable the recovery usually is. Again, it gets back to that, is it justified? The answer that I'm seeing in the historic data that can give us signal rather than noise is yes, we are emerging from a median recession from an earnings perspective that is usually durable and lasting and has strong magnitude, which is why I think that we are about to return, or we're in the stages of returning, to the secular bull market where I think that U.S. can beat international stocks for that exact reason.

[00:20:04] Pamela Ritchie: That is completely fascinating. You've got interest rates falling around the world but particularly in the U.S. so that story is sort of at the back of that. Couple of questions, I'll put these to you. Do you factor in, Denise, the U.S. government debt into your market assessment? How do you answer that?

[00:20:24] Denise Chisholm: So -ish. Always remember that there's four measures of debt. Government, corporate debt, consumer debt, financial debt. Again, when you think of what does Denise Chisholm do for a living, she analyzes historical data and looks at patterns. Those three, those final three have very clear pattern recognition as it relates to equities. So consumer, financial and corporate debt have very clear bright lines as it related to equities. This is where we were in the financial crisis. All three of those are in phenomenal shape relative to history, especially the consumer because they termed out their mortgages, debt services at all-time lows, and even debt to income is still at lower than what we saw in the dot-com bubble. We've delevered as a consumer.

[00:21:18] Those three that are predictive of future equity returns are in really good shape historically. Government debt, mind you, has gone up pretty much since 1930, or maybe since Alexander Hamilton. It has been going up the whole time. It's very difficult to draw a pattern with U.S. equities. The same is true with deficits. I can't draw any patterns. Now, the interesting pattern that you will see is if you look at total debt in the U.S., it's basically unchanged for the last 10, 12, almost 15 years. We've really had a transfer of debt. While we're focusing on one measure of debt that's going up and up and looks like a tipping point, when you look at total debt we're not really seeing anything different than what we saw over the last 15 years. From that perspective I think that that's an interesting way to think about it. So does it ... yes, it is not particularly helpful for me to say, well, it all ends up badly because I'm not sure that that's exactly the case because you can't really prove it in the data.

[00:22:20] I understand that we would think that a lot of this changes risk-rewards but I think originally the debt studies that we did after the financial crisis led us astray because we thought that there was a tipping point that we haven't actually seen yet. Again, it's back to that what if you get it wrong as an equity investor and say, government debt is what's different this time and I don't care that it hasn't been predictive, I think it's going to be predictive because it's different and you get it wrong, well, you lose out 10 percentage points of return. What if there is inflation, then you haven't hedged against that in the most effective way that you can historically, which is via equities.

[00:22:56] Pamela Ritchie: Amazing, amazing. Another question. This is a really interesting question, where are we in the economic cycle in comparison to other countries? That may be asking about where Canada is but let's say where is the U.S. in comparison cycles that other countries are going through? I mean, sometimes we're all at the same place but sometimes we really aren't.

[00:23:16] Denise Chisholm: Not this time. I would say that the U.S. is in the early stages of a potential reacceleration, maybe less in GDP, more in profits, than most other countries. It's definitely been off cycle this cycle. When we were sort of accelerating people were decelerating and vice versa. I think that that gets back to the thesis behind U.S. equities, I think, being a better risk-reward than international equities because where we are right now is given the corporate tax cut, remember I think that that is an incredibly effective thing as it relates to future earnings growth and future economic growth, in conjunction with the fact that unlike the rest of the world the Federal Reserve is just beginning yet again more accommodation normalization, so you have an accommodated Fed where the rest of the world doesn't have that happen, and you have a situation that is much more impactful in the U.S. with lower energy prices, giving yet again the gift to a consumer and corporate profit margin. I think you have a trifecta pushing the U.S. forward that is not exactly anywhere else in the rest of the world.

[00:24:23] Pamela Ritchie: That is completely fascinating. Talk to us about the data story. How is the Fed going to make its decision? There's certain types of data that are just not available that they would use, that you would use. There are other pieces of data around but it does seem like there's a big hole there. You've spoken about this in the past. What do we do about the data situation? Tomorrow's CPI will come out but there's lots of missing pieces.

[00:24:47] Denise Chisholm: They don't have the full non-farm payroll report. Again, we go back to that debate on how efficacious is that, do they have other data that can give them that? They have the JOLTS report, they have that, we have ADP, they have other areas where they can sort of get a beat on the labour market. I think we already know in the U.S. that the labour market is ... sure, it's not contractionary but it's quite weak. We saw the worst two-month negative revisions that we've seen outside of recession pretty much ever, or I think since 1968. I think that that's known-ish. I think that they need less month-to-month data and more thinking big picture in terms of long term.

[00:25:26] Remember, at the end of the day, yes, they say they're data-dependent, which means that they don't want to ignore data but at the of the end, and Chair Powell said this, I think in his last press conference, they're a risk manager so they are thinking about if I get it wrong, what's my downside? If I get it right, what's my upside in terms of inflation? I think that that's the part they're struggling with. I think that that negative payroll revision really took a lot of steam out of the hawks who thought that any accommodative monetary policy would lead to a future acceleration in terms of inflation. It's hard to get sustained inflation without a strong labour market which translates to higher wages.

[00:26:05] If we're not seeing pressure in wages, sure, you might see a reacceleration of the CPI as a function of tariffs over the next three months but when you're the Federal Reserve you're not worried about three months, you're worried about the next two, three, five years from a monetary policy perspective. I do think that as much as yes, there is a lack of data that they would prefer to have because who wouldn't like to have more data, I prefer to add more data, but I don't think that they're nearly as data-dependent on it as they say in the headlines.

[00:26:39] Pamela Ritchie: That's so interesting because, of course, they say it all the time. It is absolutely something that they've coined it that way. What would you say to the wall of worry that's here right now, just to kind of close out where we began. There's still lots of concern that there are bubbles abound and I think you pointed out lots of reasons why it may not be a crisis moment. Just to kind of close that loop, what do you think?

[00:27:07] Denise Chisholm: I think that there are two things that are the issues or the questions that I get over the last couple of days, one around the credit issues. The interesting part is from a credit perspective, on average we definitely had better credit scores even across subprime than we had in the financial crisis but when you think about household debt...

[00:27:23] Pamela Ritchie: Really?

[00:27:25] Denise Chisholm: Yes, I mean, stunningly restrictive in terms of access to bank loans you would say. I mean, that's the other side of it but generally speaking, the average borrower has much better credit worthiness than they had in the financial crisis and than they had five years ago. The interesting part, remember, we think that all correlations go to 1 because of the financial crisis but mortgages are 70% of the U.S. population's debt and we are not seeing any delinquencies. We are not seeing any rise in uncreditworthiness. That is the bulk of this. That was the difference this time in the financial crisis was that correlations went to 1. You would expect to see idiosyncratic issues within credit market. Bankruptcies actually exist but you should know that most times, and we're not really seeing any signs in the markets these days, is that they're more idiosyncratic than systemic, which I think is important. You're already seeing it in the credit markets. You had the VIX double and you had credit spreads widen out by 40%. Back to your wall of worry, when there's more fear in the equity market than there is in the credit market, even on a short term basis, that's usually a pretty good indicator.

[00:28:33] Pamela Ritchie: We will leave it there. Denise Chisholm, thank you so much for bringing us your research, we really appreciate it. Have a great rest of your day.

[00:28:40] Denise Chisholm: Thank you, always great to be here.

[00:28:42] Pamela Ritchie: That's Denise Chisholm joining us today from Boston. On Friday, we close out our week tomorrow with a fixed income portfolio discussion. Sri Tella will be joining us and taking a look at credit dynamics, as Denise was just pointing to, fixed income strategies and a real look at the Canadian economy from a bond investor's perspective.

[00:29:06] On Monday Fidelity Director of Global Macro, Jurrien Timmer, is back to unpack the macro themes on his radar, bringing you a host of charts, graphs, brilliantly artistic, gorgeous things to look at that will really set you up for your week of trade ahead.

[00:29:20] Next Tuesday portfolio manager, Darren Leckerkerker, he joins us to talk about a decade of North American Equity Class, the fund itself. This special webcast will reflect on the fund's journey, explore today's market landscape and take a look at what is ahead in the next decade, what could be brought in those years ahead. Look to that. We'll see you soon. Thanks for joining us here today. I'm Pamela Ritchie.