What a difference a quarter can make! At the end of October 2018, the ebullience in US stock markets was overflowing. The S&P 500, NASDAQ, and Dow Jones Industrial averages were all trading near or at all-time highs—continuing the historic bull market run that began in 2009. The US unemployment rate fell to 3.7% in September, a nearly 50 year low. And the US economy (measured by GDP) appeared well on its way to exceeding a 3% annualized growth rate, a level not seen since 2005.
Unfortunately, the vibrant rays shining down on the economic landscape were quickly engulfed by a storm created by multiple forces. Market sentiment quickly turned sour due to the perception of hawkish Federal Reserve activity in 2019, a contentious trade war with China, and a deceleration in economic growth abroad. From its peak, the S&P 500 declined approximately 19.5%. As the market touched this level on Christmas Eve, we stood ½ percent away from bringing an end to the longest bull market in US history. Thankfully, the Grinch couldn’t ruin all of December, and a Santa Claus rally started on the last week of the year.
As we entered 2019, whipsawed investors are questioning which quarter will serve as a more accurate depiction of things to come. No one holds a crystal ball but we do believe in the old adage that--to understand where you’re going you have to understand where you came from. In our opinion, the following four legs propelled the current bull-run: corporate earnings, accommodative Federal Reserve policy, healthy corporate and individual balance sheets, and fiscal policy. Below is a snapshot of our views on where we think each one of these legs stand.
In our opinion, the strongest leg of this bull market has been corporate earnings. Corporate earnings and revenue growth will ultimately drive the price of equities. In 2018, we witnessed one of the most impressive years for earnings generated by the companies that comprise the S&P 500. The 2018 annualized earnings growth rate should finish around 23%. As mentioned in our previous outlook, burgeoning economic growth and the dramatic shift in corporate tax policy are the primary drivers behind this ascent. With the majority of S&P 500 companies reporting for Q4 2018, we continue to see over 70% of companies beating on the bottom line and over 60% beating on the top line.
However, we are closely watching the recent decline in analyst’s estimates for the first quarter in 2019. The hurdle this year is extremely high due to the loss of the one-time tax benefit from the new corporate tax code and the impact of rising wages and input costs from a booming job market and international tariffs. Refinitive estimates the Q1 2019 S&P 500 earnings at -.5% and annual forward earnings growth rate of roughly 4%. This is a much lower growth rate from what we have seen over the past couple of years but the price and multiple of the market have also declined. Using Refinitive’s estimates for 2019, the S&P 500 is roughly trading at 16.5 times its earnings. This is a lower multiple than we saw at the beginning of 2017 and 2018 and only slightly above the long term average P/E (Price-to-Earnings Ratio) of 15.7. We think valuation may provide support if earnings growth estimates continue to deteriorate throughout the year, but we also would view this as contrary to our projected low single-digit growth rate.
Federal Reserve Policy:
Over the past 3-6 months, the most volatile leg of this bull-run has been Federal Reserve policy. In November and December, Federal Reserve Chairman Jerome Powell gave speeches that wreaked havoc into the underlying sentiment of investors (and the President). It was expected that the Federal Reserve would raise interest rates by 25 basis points in December (the 4th increase in 2018) but investors did not expect the Fed to maintain a steadfast commitment to reducing the size of its balance sheet and staying the course with rate hikes in 2019.
On January 4th during the American Economic Association meeting in Atlanta, GA, Chairman Powell made an “about-face” and comforted markets by implying the Fed would be data-dependent and flexible with its policy tools, including rate hikes and the balance sheet. These comments sparked the rally that has continued for the early part of 2019 and shifted the majority of economists and strategist’s projections towards more accommodative Fed policy in 2019. We would agree with this consensus but we also wouldn’t be surprised by one rate hike this year. The data will drive this decision.
Corporate and Individual Balance Sheets:
Of the four legs referenced in this outlook, the health of individual balance sheets appears to have the longest runway for growth. With savings rates hovering above 6%, debt to income ratios below historical averages, and incomes on the rise, the US consumer should remain a catalyst to corporate earnings and economic growth. We do not see the excessive consumer debt levels or an impetuous rise in their “animal spirits” that would lead to a rapid decline in personal consumption.
Corporate balance sheets paint a slightly different picture, though. In a historically low-interest rate environment that has an abundant supply of liquidity from the Federal Reserve’s quantitative easing program, corporations have significantly increased their debt loads to repurchase their own shares, pay dividends, or fund mergers and acquisitions. Since 2008, total outstanding non-financial corporate debt has risen by over 2.5 trillion, reaching an all-time high of over 45% of US GDP. The level of BBB rated corporate debt (the lowest rating for investment grade bonds) has more than tripled since 2009. This escalation in corporate debt loads could pose a problem with a significant rise in interest rates or a decline in corporate earnings.
The remaining leg of the bull-run is the last to emerge and appears to be the sprinter of the four. Markets rallied with the tailwind of a new corporate tax code and widespread deregulation throughout various industries. This perception has changed slightly with the recent shift in US trade policy. Economists are concerned that US tariffs on international trade could offset some of these stimulative benefits. The recent shift in power within Congress will also make it more difficult for the current administration to advance its fiscal agenda. We believe this leg will be at rest for most of the year, but its slumber will be short-lived with the upcoming 2020 presidential election.
“When it comes to the relationship between economic data and the stock market, better or worse tends to matter more than good or bad. Trend is of more consequence than level.”
The quote above from Liz Ann Sonders, Charles Schwab’s Chief Investment Strategist, is a succinct depiction of where we see the market today. Each one of the legs of this bull market is running but the pace of their growth is decelerating. At these levels of growth, we believe it highly unlikely for the US economy to experience a recession over the next 12 months. However, we see signs of late cycle characteristics. The past two quarters are perfect examples of the market reacting to a downward shift in the trend of the economic landscape followed by the realization that the levels of economic and corporate growth did not warrant such a severe drawdown. With the rise of computerized and algorithmic trading, this type of rapid volatility should be expected.
In conclusion, it is important to remember that market timing is typically a losing endeavor. Over the past ten years, the US economy has grown at an anemic pace—approximately 2.2% annualized compared to the 3.3% long-term average. The cumulative growth rate of the current economic cycle is roughly 25%--placing it significantly lower than the cycles beginning in 1961, 1982, and 1991. While tepid, the pace of economic growth has created a prolonged recovery and could also extend the later innings of the cycle.
As we look at the mosaic of indicators that make the current market environment, we would maintain a neutral allocation to equities, focusing on companies with low leverage ratios and cash flow growth. With the five year performance spread between US markets and international stock markets exceeding 7%, we also think it makes sense to increase exposure to international and emerging markets gradually. In fixed income, we would overweight investment grade credit or treasuries and prioritize bonds with low correlations to equities over bonds with excessively high yields.
We also think the recent downturn shows the importance of reassessing risks in portfolios and rebalancing. Pullbacks in markets are great ways to gauge the amount of risk someone is willing to stomach. If December’s decline inhibited sleep over the holidays, it might be time to consider a more conservative allocation. As your advisers, we are here to help you analyze the impact the next downturn could have on your financial plan and manage portfolios to help you achieve your financial goals.
Authored by Jonathan Winzeler, Chief Investment Officer