Stocks moved higher again on Friday as two high profile IPOs, Pinterest and Zoom Video made their public debuts. But elsewhere, stocks show signs that the momentum that propelled stocks back close to their historic highs may be running out of gas just as we approach the heart of earnings season. Obviously, a major deviation in earnings versus expectations could drive stock prices higher or lower, but we don’t see that happening. Rather, with stocks now selling for about 17 times forward earnings, they appear fully priced. Fully priced doesn’t mean overpriced but there are few bargains left. That’s what a 20% rally from recent lows will do.
So, what makes stocks move higher from here? The obvious answers are some combination of higher earnings, lower interest rates or a weaker dollar. I will deal with the last one first. Current values fluctuate as the relative performance of various large economies differ from expectations. The current expectations that are imbedded in current currency values are for 2-3% growth in the U.S., about 6% growth in China, and very little growth in Europe and Japan. Couple these with interest rates near zero in Europe and Japan, and you derive a pattern that shows the dollar trading in a narrow range against competitive currencies as it has been doing for almost the last year. At this point in time, I see no change in that picture. Late last year and early this year, there were concerns that slowing growth could be a precursor to negative growth in many developed economies. Logic suggested that growth slowing to a new sustainable level was the most likely outcome, but emotions overtook logic while growth was slowing. Fears ignited that recession wasn’t far away. Yield curves inverted, at least along the short end of the curve amid confusion about central bank interest rate policy.
But those fears have now subsided. Growth appears to have stabilized. There are even signs, both in China and the U.S., that some pickup could actually be in order. Interest rates remain low but have bounced a bit in recent weeks, still well below fall 2018 levels. Earnings in the first quarter are still going to be flat or down slightly but that is almost all due to year-over-year strength in the dollar that will dissipate as we move further into the year. Our 2019 estimate for S&P 500 earnings of about $170 is virtually unchanged from last fall.
What has changed, and probably the biggest catalyst behind the stock movements of the past several months is the outlook for interest rates and inflation. As the 10-year Treasury yield crossed 3% late last year, estimates of 3.0-3.5% within 12 months were common. But now as the 10-year Treasury yield stabilizes in the 2.5-2.6% range, 3.0% seems a bit far away. In addition, the 3-month to 10-year spread, which briefly turned negative, is now positive once again and the 2-10 year spread is back to 20 basis points at the high end of the range over the past six months. Fears of a recession within the next 12 months have faded. Certainly, there are economists who always have a recession in their forecast 1-2 years out, but I would counter that predicting the economy 2 years out is about as simple as predicting weather two years hence. Anyone suggesting recession in the not-too-far distant future needs to demonstrate why a rather well-balanced world economy is going to become imbalanced.
That doesn’t mean stock markets can’t get ahead of themselves leading to a bear market within an economy that is still growing. We saw this in both 1987 and 2000. In both cases, an overly exuberant IPO market was the catalyst. Today, at least we are having a robust IPO market but, for now, exuberant isn’t a word I would use to describe it. But clearly, that segment of the market bears watching particularly as the very large offering of Uber approaches. Note that it isn’t usually the public offering of real high profile names that signals an end to a bull run. Rather it is the second derivative follow-ons of overvalued second and third generation wannabes that signal too much hype and precipitate a large correction. That could be months or years away. Or it could not happen if the IPO market never reaches a supercharged state.
With that said, stock prices are a function of supply and demand. IPOs provide more supply. More supply without more demand would mean lower prices, all other factors being equal. Also note that a company’s IPO may only be the tip of the iceberg. Most offerings involved a relatively small number of shares. The real bulk of increased supply comes when a lockup period ends, usually within 3-6 months of the actual IPO. The lock up period is that interval after the IPO when insiders, both management and early private investors, are forbidden from selling stock. Once the lockup periods end and selling begins, there is often pressure on a company’s stock price.
Obviously, for every seller there has to be a buyer. Often funds to buy come through sales of other stocks. Therefore, in a high volume IPO environment, buyers will have to sell other stocks to raise money to buy the new names investors find attractive. If you recall the Internet bubble of the late 90s, tech stocks rocketed higher while much of the rest of the market marked time.
Today, it is much too early to suggest a recurrence. We have only had a handful of high profile IPOs to date and few of any size have gotten past their lockup periods yet. Over the past several years, a catalyst for higher stock prices have been elevated levels of share repurchases. Many companies continue to fund repurchases through rising free cash flow. Others, which had borrowed money to fund their buying have slowed the pace of repurchases. Fewer repurchases and the specter of more new stock flowing out of the IPO market suggest less positive momentum ahead for the overall market.
With all this said, the primary catalyst for rising stock prices is earnings growth. After a flat-to-down first quarter, we expect solid 5-10% earnings growth over the rest of 2019. Next year, earnings could be close to $180 for the S&P which would price the market at 16 times forward earnings, close to historic norms. But with interest rates well below historic averages, modest further upside is possible.
The net is that stocks can move higher over the next 12-18 months but at nowhere near the pace of the first three months of this year. With interest rates likely to stay low, money could flow from bonds to stocks, helping to offset the headwinds of added IPO-related supply. Slow growth implies some volatility and leaves open the possibility/probability of a 5-10% correction at any time. Such corrections, if they occur, would represent the best buy opportunities from here. Earnings season, now upon us, also creates opportunities when investors overreact to slight quarterly earnings shortfalls.
Today, Jack Nicholson turns 82.
James M. Meyer, CFA 610-260-2220