We hold a constructive view on U.S. equities. We believe a year of muted earnings growth in 2019 (against a backdrop of uncertainty and sluggish economic growth) paves the way for earnings growth to recover into the mid-high single-digit range. Consensus 2020 earnings growth estimates for the S&P 500 have fallen from an 11% high earlier in 2019 to just above 9% currently and are showing signs of stabilization (see bar chart below). Earnings growth in the mid-high single digits is reasonable against a backdrop of an improving global growth scenario and waning strength for the U.S. dollar.
Did You Know?
The S&P 500 has historically posted double-digit gains (on average) following each of these occurrences that are all happening now:
- U.S. yield curve inverts, then re-steepens
- U.S. Federal Reserve cuts interest rates during periods of expansion (insurance rate cuts)
- U.S. Presidential election years
The S&P 500 remains the most diversified equity market in our universe and contains some of the best secular growth opportunities. However, it’s also the most expensive market on our list (see bar chart below). While everyone would prefer the opportunity to buy equities at cheaper valuations, we must deal with what is and not what we would like. The reality is the current backdrop should see equity valuations higher than otherwise. The U.S. Federal Reserve guiding markets toward no further rate hikes and demonstrating they are prepared to provide ample liquidity is an environment supportive of valuations. Additionally, the prospect of low inflation and contained bond yields also inflates valuations, as does any improvement to sentiment, economic conditions or earnings estimates. Given this backdrop, we’re prepared to assign an elevated earnings multiple to U.S. equities, but the way forward remains fraught with uncertainty. While we see a path toward improvement in the economy, trade and earnings growth, U.S. equity markets have already moved a significant way toward the optimistic side, leaving little room for disappointment.
Markets are currently buoyed by the notion that global economic activity is bottoming out and set to improve (as is our base case). However, at the bottoms of prior mid-cycle slowdowns that bear a resemblance to the current episode (1995, 1998, 2012 and 2016), equity markets faced a better fundamental starting point than does the current market. On average, GDP growth troughed at higher-than-current levels, earnings growth only averaged ~8% (versus expectations for more than 9% at the current time) and forward price-to-earnings multiples averaged 16.3X (versus 18.3X). One caveat that stands in contrast to this divergence, and is a positive for equities, is that the overall backdrop for yields (outside of the 2016 episode) started at a much higher-than-current level.
In spite of our overall constructive outlook for U.S. equities in 2020, we do have some near-term concerns that temper any desire to overweight the region
- Specifically, our concerns stem from the rapid and sharp advance U.S. equities have made in the last several weeks of November. The complete set of S&P 500, Dow Jones Industrials, Nasdaq and Russell 2000 Indices registered over-bought conditions late in the month. Prior instances with similar run-up in equity prices have more often than not led to periods of consolidation, marked by single-digit check backs. Our experience gives us the confidence to trust these tactical indicators and avoid the temptation to chase recent gains. U.S. equities are currently pricing-in the better-than-feared global economic scenario we hold as our base case for 2020. Furthermore, U.S. equities are also pricing-in a trade détente. Rumours and green shoots surround both outcomes, but equities likely require recent gains to be consolidated and further tangible evidence the clouds are indeed going to part in 2020.
- Aside from the near-term run-up in stock prices, other issues facing the U.S. market give us reason to pause. Share buybacks have been an important metric that have helped shore up S&P 500 earnings per share. They’ve also been a source of demand for equities (S&P 500 share buybacks of USD $806 billion set a record in 2018). Share buybacks trended downward from that record-setting pace in 2019 and the trend is likely to continue. Buybacks are still providing a lift to U.S. equities, but the impetus is waning.
- A third U.S. equity concern stems from the S&P 500’s sector breakdown. While the index is better diversified than most, it currently exhibits some characteristics that bear watching. Four sectors have contributed 65% of the S&P 500’s last two-year return: Information Technology, Health Care, Consumer Discretionary and Communication Services (the revamped home to former tech companies like Google, Netflix and Facebook). Of the four, Information Technology stands out with a 48% cumulative total return since November of 2017 and accounts for 37% of the S&P 500’s 2-year return, despite being just 21% of the market weight. Aside from Health Care, the other three sectors currently display very extreme valuation metrics, with many measures above two-standard deviations from the last 10-year norm. Granted, these sectors are home to many strong growth opportunities, and all but communications services have delivered very steady and rising earnings growth that investors crave and have been willing to pay handsomely to own.
However, these same sectors are also home to the kinds of businesses that have a high propensity for disruption over time and are currently a target for regulatory reform – increased scrutiny that’s likely to crimp their ability to continue to succeed at the same pace going forward. For the Health Care sector, politicians on all sides are taking aim at controlling drug costs, health care spending and efficiency in general. The spectre of increased regulation looms over sentiment in this sector, and any actual implementation would most likely be a negative for shareholders. For the Information Technology and Communication Services sectors (and also Consumer Discretionary since Amazon is included in there), two issues lurk: privacy and anti-trust. Consumer protection relating to technology is at the forefront of the privacy debate and the prospect of greater competition (leading to lower prices), are areas ripe for politicians to exploit. Privacy regulation may hinder the data and targeted advertising business models of these organizations. Their growing size and market dominance are also fueling concerns that some of the larger players may need to be broken up in order to restore competition (Alphabet/Google, Amazon and Facebook in particular). Increased government regulation and anti-trust investigations would be unwelcome events for shareholders in these businesses.
Bottom Line: We recommend a neutral position in U.S. equities. The S&P 500 remains the most diversified equity market in our universe and contains some of the best secular growth opportunities. However, U.S. equities remain expensive compared to their global counterparts on most valuation measures. Accommodative monetary policy and the low bond yield backdrop support higher valuations than otherwise would be the case. A less pessimistic outlook on economic growth, earnings growth and trade tensions can also justify these higher valuations. However, the current level (3141 on Nov. 30, 2019) reflects a high degree of optimism that a global reflation, trade détente scenario comes to fruition and leaves little room for disappointment.
Our base-case scenario for the S&P 500 calls for the forward P/E multiple to hold steady around 18X and the trailing multiple to contract slightly from 21X to 18.5X. Earnings growth in the mid-high single digits (against these valuation metrics) drives a 4% price-only return for 2020 (see table below). When coupled with the estimated 2% annual dividend yield in 2020, we expect a total return of 6% in U.S. dollars for the year ahead.
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This commentary represents GLC’s views at the date of publication, which are subject to change without notice. Furthermore, there can be no assurance that any trends described in this material will continue or that forecasts will occur; economic and market conditions change frequently. This commentary is intended as a general source of information and is not intended to be a solicitation to buy or sell specific investments, nor tax or legal advice. Before making any investment decision, prospective investors should carefully review the relevant offering documents and seek input from their advisor.