Stocks were mixed yesterday on a day when Fed Chair Jerome Powell began two days of presentation and testimony to Congress. Today, in addition, Trade Representative Robert Lighthizer is scheduled to go before the Ways and Means Committee. He is a trade hawk and could set a tough tone through his replies specifically toward protecting intellectual property, forced technology transfers, and open markets within China for American companies. In recent weeks, President Trump has sounded much more anxious to make a grand deal than Mr. Lighthizer. But Lighthizer knows who his boss is and one would expect him to parrot Mr. Trump’s views rather than his own should they differ.
When stocks were setting new lows in early winter, I noted that many of the storm clouds of the moment would dissipate by the end of the first quarter. Look at the list below:
- How far would the Fed go raising rates? – In December it raised them for the fourth time in 2018. Earlier in the fall it had hinted that about three more increases might be coming in 2019 in addition to a forthcoming reduction in the size of the Fed’s balance sheet of as much as $2 billion. Now it appears that the Fed is done raising rates at least until mid-year and maybe for longer. As for the balance sheet, the runoff could end this year. In summary, the Fed isn’t today’s problem any longer. The softening of Fed policy is the single biggest reason for the market’s recovery since Christmas.
- China trade/tariff talks – Right now there is a 10% tariff on roughly half of what China exports to the U.S. and similar tariffs on what we ship to China. At the moment, both sides are sweet talking each other with a grand plan set to be signed in the spring. Whether that grand compromise has a lot of teeth or not remains to be seen. Both Presidents Trump and Xi tend to overstate the benefits. But for investors, that doesn’t matter as much as the removal of fears that the trade war might escalate. China was never going to do a 180 degree about face and the U.S. simply has to take steps in the right direction for Trump to declare that he is making progress no other recent President has made. This too seems to be ending well.
- The government shutdown – Never an important economic item to begin with, it is unlikely Mr. Trump wants to unilaterally shut the government down again. With that said, there will be other battles to come and there are few signs so far how the White House and Democratic leadership will be able to find common ground.
- Brexit – No resolution yet but the March 29 deadline now looks likely to be postponed. No one wants a hard disruptive exit and all sides seem willing to keep punting the ball down the road until some sort of compromise can be reached. European economies have been hurt a bit by the Brexit proceedings, but the situation is no worse than previously anticipated.
As these storm clouds have dissipated, stocks have moved higher. Today, equity values are back to or even slightly above fair value. At the end of last year I gave a 2019 year end target of 2790 and we are about there now. I got that number by taking the average P/E on forward earnings of 15.5x and multiplying it times a 2020 estimated earnings of $180 for the S&P 500. Given the slowing pace of economic growth and continued strong dollar, I see no reason for any change in forward earnings estimates. In fact, there could even be a bit of disappointment in the first half of this year as signs point to some softening consumer spending trends.
But one can make a case that using the historic average P/E of 15.5 may be conservative. The Fed has targeted long term inflation of 2.0% and has used a multitude of tools since the Great Recession to try and get inflation back up to that target level. While it did succeed momentarily last year with the benefit of a huge tax cut and expansionary fiscal budget, it hasn’t found a way to sustain that. It certainly doesn’t want to start rapidly increasing money supply or revisit QE again with an economy that may be near full employment.
The answer simply may be that in a world where the Internet makes price discovery so efficient that inflation can’t get to 2% without an overheated economy. Technology has not only forced sellers to keep prices down, it has also lowered the costs of doing business.
The bond market has picked up on this message. During most of the 2019 stock market rally, bond yields have barely budged and the yield curve has kept its same shape. That suggests fears of recession haven’t increased as growth slowed. But the fact that long rates remain about 50 basis points below their December highs, despite a robust stock market, suggests that an economy can continue to grow without any increase in inflation expectations. If core inflation is only to be 1.50-1.75% instead of 2%, the market’s P/E on forward earnings could be more like 16.0-16.5x or even higher. If I use 16.5x and multiply it times the same $180 estimate for 2020 (I use 2020 because by the end of 2019 we will be looking at 2020 earnings), a target could be as high as 2970.
That doesn’t mean we should be there today. It means that’s where the math suggests we should be at the end of this year. That implies just 6% growth remaining for the year, and I doubt we will get there without at least one 10% correction. But it does mean that as long as inflation stays low and the bond market remains near present levels, the recent gains appear justified.
Today, Josh Groban is 38.
James M. Meyer, CFA 610-260-2220