Equity markets also continue to monitor the Fed’s tightening cycle and the moderation of economic growth abroad.
To read the full article from Mike Gibbs and Joey Madere, CFA, see the Investment Strategy Quarterly publication linked below.
We recognize the heightened risk environment, but feel the sharp weakness in December is overdone for the short term. Moreover, we do not feel the recent weakness is the beginning of a lasting bear market for equities. We expect U.S. economic concerns to be proven premature as U.S. GDP will likely reach low- to mid-2% growth in 2019. Earnings growth for the S&P 500, while slowing from the unsustainable 20+% growth rate of 2018, will still be healthy as we project 5% to 6% growth for the year.
Attractive valuation further supports a positive bias with the S&P 500 price-to-earnings ratio (P/E) trading under 15x, relative to the long-term historical average of 16.5x (and 22% lower than the September peak P/E of 18.8x). Our base case S&P 500 target of 2,957 by year end 2019 renders 25% upside price movement from the December 24 close of 2,351.
Despite our bullish posture, we admit a lot needs to go right in the year ahead to achieve our target. With delicate issues, such as the U.S.-China trade talks, a volatile road lies ahead.
Trade negotiations are expected to remain the center of investor focus in 2019. Despite the G20 “trade-truce,” challenges to a “deal” are elevated with both sides appearing hardened regarding intellectual property rights. For this reason, reaching an agreement by the 90-day deadline suggested by President Trump is unlikely. Nonetheless, we feel the two sides can and will deliver a message of progress to reassure the financial markets as the deadline nears. With the stakes (to global sentiment) high, we are optimistic both sides can arrive at acceptable terms as the year progresses. Stock market volatility will likely remain elevated with the path to an agreement rocky.
Investor concern over the health of the economy is heightened, with housing trends softening and initial jobless claims ticking slightly higher. The softening trends are likely noise, in our opinion, and with the economy late cycle, uncertain readings are not a surprise. Conversely, other economic readings, such as unemployment, leading indicators, consumer confidence, and Institute of Supply Management (ISM) surveys, all point to a healthy environment.
The flattening yield curve, often a signal of pending economic weakness, adds to investor angst. The narrowing spread between the 2-year and 10-year yields (as low as 10 basis points, or 0.10%) stoked concern in early December. We are watching yield spreads, but since we put more weight on the 10-year and 3-month yield spread, we are not overly concerned at this point with it comfortably above the zero mark (0.30%). Long lead times to recessions after previous yield curve inversions and false signals cause us to refrain from overconcern at this point, as well. Nonetheless, with investors focused on the shape of the yield curve, it is likely to influence equity market direction, at least over short periods.
Our belief that inflation will remain anchored and interest rates will not run away to the upside further supports a positive bias. Low global bond yields and the likelihood of only one Fed rate hike in 2019 should keep the U.S. 10-year Treasury yield from spiking again. As a reminder, in 2018 a jump in interest rates triggered both 10% drawdowns in the equity market.
Fundamentally, earnings are set to slow from the 20%+ growth in 2018. There has been plenty of noise around “peak earnings,” but it is a mistake to confuse “peak earnings growth” with “peak earnings.” We estimate earnings will grow 5% in 2019 to $169 per share. Such growth, if realized, is adequate to support higher equity prices. The overhanging issues and technical damage done during the decline will limit equity upside in the coming months. Negative headlines will influence stocks to test the low end of the range. However, a healthy U.S. economy, a growing earnings stream, and attractive valuation should serve as downside support. We believe the current pullback is overdone in the short term. Success or failure with trade negotiations will likely influence the equity markets next significant directional move.
In our base case scenario for 2019, trade issues linger, but enough progress is made (by year end) to allow a more positive tone. Our base case assumes that the U.S. economy does not falter, the Fed pauses the tightening cycle after one move in 2019, the Treasury yield curve does not invert as measured by the 3-month to 10-year spread, and earnings rise as expected. We apply a P/E of 17.5x to $169 in earnings to reach 2,957 (+25%, as of December 24). Our P/E adequately discounts late-stage economic risks, which will likely linger. We place a 65% probability of this scenario playing out.
Our bull case scenario for 2019 is a “Goldilocks” environment in which trade differences are worked out more rapidly (and without as many issues as feared), the U.S. economy hits its targets, inflation remains muted, the yield curve steepens in a controlled fashion, the unemployment rate stops falling (allowing the Fed to pause the tightening cycle), and investor optimism returns. We use a 19x P/E, which was the P/E at the September peak and has been the historical median P/E when inflation is in the 2-2.5% range. Earnings surpass our estimate and reach consensus forecasts of $174. Applying a 19x P/E to $174 earnings gets a 3,306 bull case scenario (+40% from current levels).
In our bear case scenario, the trade conflict escalates and slows economic and earnings growth (without entering a recession). Our base case assumes that the Treasury yield curve inverts as measured by the 10-year and 2-year spread and the Fed stops tightening and leans toward looser policy (which helps to limit the downside in stocks). In this scenario, we feel earnings will be flat with 2018 (~$161). Negative sentiment could keep the S&P 500 P/E down near 15x (~9% below the historical average of 16.5x). Applying a 15x P/E multiple to $161 earnings results in a bear case scenario of 2,415 on the S&P 500 at 2019 year end (+2% from current levels before dividends and -17.5% from the 2,930 September peak).
In summary, we have a positive bias to equities over the next 12 months and believe the current pullback is overdone for the short term. We view valuation as attractive and expect supportive economic and earnings growth. Numerous factors are impacting the environment and investor sentiment (on the positive and negative side). These factors will not go away anytime soon. Therefore, for the next several months and possibly into mid year, the S&P 500 is likely to remain volatile as investors balance the headwinds and tailwinds. If the U.S. and China eventually work out trade differences and the U.S. economy remains healthy (two outcomes we expect), improving investor sentiment and solid earnings may allow equities to post healthy gains by the end of 2019.
All expressions of opinion reflect the judgment of Raymond James & Associates, Inc., and are subject to change. There is no assurance any of the trends mentioned will continue or that any of the forecasts mentioned will occur. Economic and market conditions are subject to change. Investing involves risk including the possible loss of capital. The S&P 500 is an unmanaged index of 500 widely held stocks. It is not possible to invest directly in an index. U.S. Treasury securities are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. Price-to-Earnings Ratio (P/E) is a ratio for valuing a company that measures its current share price relative to its per-share earnings. Past performance may not be indicative of future results.