Stocks continued to move higher as the Santa Claus rally continues. Economic reports worldwide continue to indicate that the 2019 growth slowdown appears to be ending. Interest rates are starting to climb, consistent with stronger demand. The 10-year Treasury yield at close to 1.95% is up almost 50 basis points from mid-summer lows. While negative interest rates are still prevalent around the world, they are much less so than they were earlier in the year.
Valuation is a headwind and you are seeing signs that price matters, particularly among some of the high growth names that grabbed so many headlines in recent years. Amazon’s stock has lagged the market this year essentially trading flat despite performance in line with prior expectations. Netflix has been another notable laggard. Domestic growth has slowed and the company is just beginning to see new streaming competition from the likes of Disney# and Apple#. The company is pointing investors toward significant growth overseas, but if U.S. performance is a harbinger of what will follow a few years later worldwide, then the underperformance is understandable. Last week, Lululemon, a fashion retailer that can do no wrong, had great earnings that beat expectations. But its share price dropped, an indication that beating earnings wasn’t enough; it had already been priced in. Nike reported last night and its shares are likely to fall this morning.
These are some of the stocks that led the market up. They were among the first leadership names to stall. Others could follow. For instance, lately the semiconductor stocks have been on a tear. Micron, a major manufacturer of memory chips reported this week and said the bottom for industry demand and pricing has been reached. But isn’t that news that has been discounted for the past several months? We will find out whether that was fully discounted or not over the next several months. Bank stocks have moved sharply higher along with rising interest rates and a steepening yield curve. They could move higher yet but require still higher rates and a further steepening of the yield curve. If the economy is reaccelerating both are quite possible.
Option premiums on short-to-medium dated put options have been rising as many hot money traders expect some sort of correction in early 2020. After the first of the year, corporations will have to suspend stock repurchase programs until after earnings are reported and taxable investors who deferred realizing capital gains late in 2019 may cash in once New Year’s passes. But this is all hypothetical. We went all of 2019 to date without anything more than a 5% correction. That doesn’t make one or more next year a certainty, but complacency can be a trader’s worst enemy.
With all this said, short term corrections that merely are part of a two-steps forward, one-step back normal pattern aren’t to be feared. Markets aren’t a one-way street. When values disappear, corrections make them reappear. That means one always has to be respectful of value and not chase momentum. The stock you loved at $50 but is now $70 isn’t a steal if it falls back to $65. Pick your buy points and wait. You won’t get everything on your shopping list but you will get some things.
Economically, 2020 is shaping up to be a good year. The Fed is keeping rates low and doesn’t appear likely to be active, at least through the first half of the year. More fiscal spending, the lack of excess inventories, and strong consumer demand suggest GDP growth could accelerate a bit in 2020 and that means stronger earnings. If the threat of more tariffs diminishes, as one might expect in an election year, capital spending growth might resume. Corporations will continue to buy back shares and raise dividends.
But valuation is still a headwind. Stocks now trade at close to 18x forward earnings, not crazy outlandish, but high. The big risk for 2020, in my view, is a higher-than-expected rate of inflation and, as a consequence, interest rates high enough to cause a decline in P/E ratios that could offset the benefits of earnings growth. Assuming the economy moves higher, and interest rates are higher at year end 2020 than they are today, for the stock market to have a solid year, the cyclical laggards of 2019 have to turn around and stage a solid recovery. Specifically, that means that industrial, energy and basic material companies have to lead. Banks would also be beneficiaries of higher rates, a steeper yield curve and better loan demand. On the other hand, higher rates would hurt so-called bond proxies like utilities and some REITs, stocks that were leaders for much of 2019. If I had to pick an S&P 500 target for 2020, I would suggest a range of 3200-3500 with the higher end of the range requiring the 10-year Treasury yield to stay below 2.5%. Should rates reach 3%, quite possible if growth or inflation is stronger than expected, stocks will have a tough time making headway. Either way, I don’t see a case today for recession or a big long-lasting correction.
The other risk everyone talks about is the pending election. I have no clearer crystal ball than anyone else, but I will simply make two points based on history. First, candidates with significant non-centrist views seldom win. Americans want improvement but they don’t generally want to tear down and start anew. My guess is that by the time the Democrats pick a candidate, the most extreme proposals will have been put out to pasture. Already, for instance, Senator Elizabeth Warren talks less of Medicare-for-all and more about offering everyone a Medicare option. Second, campaign proposals have long hard paths to follow to become law. Most don’t make it. Tax rules may change but not to the extent many are suggesting. Let me simply offer two non-tax cases in point. Everyone agrees we have an antiquated infrastructure and almost everyone thinks drug prices are too high. We have been hearing this since the start of the Clinton administration almost 28 years ago. And we still have aging infrastructure with no roadmap to fix it and our drug prices are still higher by far than anywhere else in the world. The stock market realizes this and, therefore, isn’t in a panic that the election of 2020 is going to bring with it economic collapse. Usually, markets are right.
Today, Jonah Hill is 36.
James M. Meyer, CFA 610-260-2220