Stocks continued their march to record highs as all indications point to global economic improvement led by a strong consumer. The economic improvement is pushing stocks to record levels as it also leads to higher bond interest rates and a steeper yield curve.
The obvious question today, with stocks marching to new highs almost daily, is whether we are seeing a fundamental shift in the economics that drive higher equity prices or whether momentum is creating complacency that will come back to haunt us before too long.
The answer, as you might expect, is a bit of both. Fundamentals are improving. Only a few weeks ago it appeared that GDP growth in the U.S. in the fourth quarter could be less than 1%. Now 2% is becoming the mean expectation. The difference isn’t the consumer. He has been a robust spender all along, not only in the U.S. but worldwide. No, the difference is on the industrial side. Strong demand is finally helping to bring the industrial recession to an end. The liquidation of excess inventory is finally coming to an end. Certainly, a reduction of tariff pressures over the past week has helped at the margin. While most of Wall Street was operating on the premise that the December 15 tariffs on Chinese exports wouldn’t take place, corporations couldn’t make long term investments amid the uncertainty that prevailed until the threat went away.
Probably the most important factor that has been lifting markets since early October has been the combination of more accommodative monetary policy all over the world and a shift in many geographies toward increased fiscal spending. In regard to the latter point, the new spending appropriations here, hints of more spending in Germany, a pledge by U.K. Prime Minister Boris Johnson to increase spending, recovery in Brazil, and steps within China for added government spending to offset declining growth rates are only some examples. The aftermath of strikes in France are yet another example. The ripple effects are just beginning to flow through. After three anemic quarters for corporate profits, some small improvement is likely this quarter with acceleration now forecasted throughout most of 2020. Thus, where last summer it appeared that S&P earnings might fall below $170 next year, it now appears that $175-180 is more likely.
With that said, even using the high end of the range, stocks now sell at 17.7x 2020 estimated earnings. Even in an era of low interest rates, it is hard to label the stock market cheap by any historic standard. Moreover, if one looks at the value of equities compared to GDP, stocks are at very lofty levels.
Last year, if you recall, the stock market took a 20% tumble in the fourth quarter reaching a low on Christmas Eve. Much of the gains this year, therefore, represent a recovery from those lows. The decline last year was precipitated by fears of tight money after 4 interest rate increases by the Fed, concerns about Brexit (which still hasn’t happened and may not for another year), worries that China was slowing faster than expected, and tariff concerns. The interest rate on 10-year Treasuries peaked just as the decline was beginning at about 3.25%.
This year’s picture is quite different. While China’s economy continues to grow at a slower pace, and Brexit remains a concern, neither seems as bothersome as it was a year ago. The 10-year Treasury today vacillates between 1.85% and 1.90%, far lower than last year. No one talks of an inverted yield curve any more. Negative rates still exist in Europe but they are fading and could disappear altogether in 2020 if European GDP rises as expected. Thus, there are good reasons for valuations to be higher now than a year ago.
And they are. At the end of 2018, the S&P was around 2500. Today it flirts with 3200. Stocks were cheap a year ago after the false alarms in Q4. But the 700-point advance since, without much change in the forward-looking profit outlook suggests most of the good news is priced in. It would also appear that markets are pricing in a Trump reelection on a day when the President is likely to be impeached by the House of Representatives. Whatever, your personal feelings about Mr. Trump might be, markets appear comfortable that he will not disturb an economy going forward that could sustain 2-3% growth without meaningful inflation. That could change as the Democratic field narrows, particularly if public opinion polls suggest a Democratic sweep. I will leave the politics to others and simply attempt to interpret reactions. You can label the election as a threat to markets in 2020. They can be, but only if investors sense a significant post-2020 change in the economic outlook predicated by the election outcome. Right now, that isn’t the case.
That brings me back to my original point about possible complacency. Normally, at the end of a very good stock market year, taxable investors defer sales into the following calendar year for obvious reasons. Mutual funds did their tax selling and window dressing in October. Hedge funds tend to be inactive without the need to raise substantial money for fund liquidation requests. Cash on the sidelines has been chasing the market’s momentum and is now well below average levels. Thus, the set up is there for some sort of correction early in 2020. That isn’t necessarily a prediction. If a correction was that obvious, there would be more selling today. But with that said, there hasn’t been anything more than a 5% correction this year, a market abnormality. One is due, the only question is when. However, modest-to-moderate valuation corrections aren’t to be feared. They happen quickly and get reversed almost as fast. It isn’t uncommon for markets to correct 10% and then recover fully, all within a 6-8 week period. If you can time it perfectly you can make a few bucks but these corrections tend to be vicious at the beginning and end while the subsequent recoveries can be just as swift. Thus, if you miss the first 2-3% down and miss the same 2-3% up at the end, your captured gains would be closer to 5% than 10%. And that assumes you still move very quickly.
Economically, our economy is in fine shape. Just today, we saw a robust housing report, the best since the Great Recession. Fannie Mae is predicting another 10% improvement next year. Housing alone can provide a quarter to a half point improvement in GDP. Thus, while I think valuation will keep next year’s gains below 10%, we remain in a sustainable solid economic growth pattern with low inflation. The main risk in my mind is that interest rates surprise to the upside. If 10-year Treasuries return to the 2.5-3.0% range, that could stall the recovery in stocks. That doesn’t mean a bear market, but it does suggest the possibility of a year of below average growth. Right now, everyone is bullish and that is often the time to be a bit careful. That doesn’t mean sell but it does mean chasing momentum can have negative consequences.
Today, Christina Aguilera is 39. Stone Cold Steve Austin is 55. Brad Pitt turns 56. Steven Spielberg is 73. And finally, Keith Richards turns 76 looking a lot better than he did 30 years ago!
James M. Meyer, CFA 610-260-2220