As we enter the home stretch, 2019 shapes up as one of the best years in decades. The S&P 500 is up just shy of 30%, virtually identical to 2013.
Since World War II, the market has risen about 30% or more six other occasions. Four of those occasions followed down years. 2019 would be the fifth such occurrence as markets fell in 2018. But the real question is “are there any patterns that might suggest what 2020 will be like?” The best single year, a 45% gain in 1954, was followed by another gain of over 26% in 1955. 1954 was the first of three up years in a row. 30%+ gains in 1958 and 1975 were followed by much more modest up years. The best streak was 1995-1999 with two years of gains of over 30% and three other years of gains totaling 19.5% or more. Anyone who recalls stock market history will know these five years were Internet bubble years. The bubble finally burst in 2000 and markets then fell for three years in a row for the first time since the Great Depression.
Thus, the answer is that little can be discerned about the market’s future from a year of outsized gains. The only constant to be determined from a relatively small sample size is that very strong years since World War II have been followed by another year of gains of more modest proportions. This doesn’t take into account any fundamental factors such as economic growth rates, interest rates or relative P/E ratios.
Looking ahead through a fundamental lens, the U.S. and world economies seem to be improving slowly, led by an active consumer. As happens during extended periods of good economic times, borrowing standards are being loosened. Credit rating firms competing for business are also giving better credit ratings than they should in some cases. I don’t see that we are in a credit bubble, but the tendency in good times to spend more freely, sometimes to the point of overextension, needs to be watched. This is a pretty persistent behavior pattern as the pain of prior tough times fades further into the past.
Investors tend to overpay later in a bull market cycle as well. Valuations today are high, very extended by some measures such as the ratio of the value of equities to GDP. But there are few signs that valuations are in a bubble-like state as they were in mid-1987 or early 2000. Whether we are closer to 1997 or 1999 is an open question. It is safe to say, that assets aren’t cheap and returns over a long term horizon, i.e. more than 10 years, suggests annualized returns for equity investors today, looking out 10 years or longer, will be less than they were when stocks were just clawing themselves out of the Great Recession. But with investment grade bonds yielding less than 3% and cash returning less that 2%, returns from equities may still be the best game in town.
Thus, looking at 2020, the positives are favorable growth rates, the likelihood that earnings growth will expand, perhaps meaningfully, and there will be less headwinds from a strong dollar. The risks are that rising wages could pull inflation and interest rates higher next year, perhaps above current subdued forecasts. The other obvious risk is the 2020 election, but until the Democratic candidate comes into clearer focus, markets will wait to adjust. From what we have seen so far, the most radical ideas regarding economic issues, like major tax changes, are getting less than a mixed reaction even within the Democratic party.
Some may note that President Trump’s tendency to create chaos is a threat but after more than three years, the tweets by themselves create much less reaction than they did just a year or two ago and most of the time, the momentary reaction is quickly reversed. We also should remember that the President uses the stock market as a measuring stick of his performance. To the extent he can influence its course, his actions would be more positive than negative over the long term. I say that with the understanding that there is very little he can do by himself to fundamentally lift the economy and equity values.
Thus, as 2019 comes to an end, it seems that investors are justified to keep a smile on their faces as long as they understand that 2019 is not likely to be repeated in 2020. But after such a nice year, any further gains should be sufficient. Actually, with all the tumult that will follow the impeachment trial, the election campaign, and other worldwide events that are sure to unfold, 2020 could be a rather quiet year in the market looked at from 30,000 feet, although I would be surprised if we escaped a 10%+ correction once again as we did in 2019. A correction without a fundamental cause, however, shouldn’t be feared. It may be painful for a moment but stocks should bounce back.
Today, Matt Lauer is 62.
James M. Meyer, CFA 610-260-2220