Looking Back at 2019
2019 began with a grim outlook for stocks but ended strong as optimism about the economy improved. The change in market sentiment occurred for two reasons:
- The Federal Reserve Bank’s reversal on interest rate policy and
- The de-escalation of the Trade war with China.
Those two factors allowed the S&P 500 to rise 8.53% during the final three months of 2019 and 28.88% for the year, making the U.S. one of the best places in the world to invest. Bond prices, which move inversely to their yields and usually opposite of stock prices, also fared well. The yield on a 10-year U.S. Treasury note was 2.69% on December 31, 2018 and closed the year at 1.92%. In other words, bond prices rose with the Barclays aggregate bond index up 8.72% in 2019.
At the start of last year, market expectations were very low. This pushed the forward 12-month S&P 500 PE ratio down to 13.9x and paved the way for positive earnings surprises and allowed stocks to climb higher correspondingly. The forward 12-month S&P 500 PE ratio began 2020 at 18.1x. So, stock investors are paying more for less
(earnings) in 2020.
From Better Than Feared to Less Than Expected?
Remember, the stock market is a discounting mechanism and does a great job of predicting what will happen in the economy over the next 6-12 months. This means that the strong 2019 stock returns, especially in the latter half of the year, factor in that the economy will be strong in 2020. This is the opposite of one year ago when the market was expecting a weak economy and possible recession
In order for earnings to “catch up” to stock prices, 2020 S&P 500 earnings must grow at a rate of 25% just to get back to “normal” historical valuation levels. We feel this is very optimistic and are expecting 8%-10% earnings growth in 2020. Not a recession, but not the explosive growth currently priced into the market.
Current optimism and excessive pricing give stocks a smaller margin of safety in the event of any unforeseen factors arising. We expect the US economy to be fine in 2020, however, the risk for a stock market correction has increased given that prices have risen beyond their sustainable earnings expectation trends.