By Troy Harmon, CFA, CVA | Chief Investment Officer
Before we get into our expectations for 2020, let’s review the backdrop from which we will experience the New Year. From trade war to mid-east unrest and impeachment, 2019 has been full of economic and political news, which could have driven portfolio returns lower, but riding a triple rate cut tailwind, we sit in late-December with year-to-date gains in excess of 31% on the S&P 500 index.
The market rebounded in early 2019 from a significant decline in late 2018 when fears of economic slowing and higher interest rates drove stock prices almost 20% lower. With earnings showing gains in the first and second quarter of 2019, financial markets followed higher, leaving S&P 500 total returns (including price appreciation and dividends) at 20.55% for the first nine months of 2019. However, third-quarter earnings (reporting in October) showed a contraction of 1.08%. The sector leaders in earnings contraction were Energy, which lost 37.6%, and Materials which saw a 14.4% drop in earnings. Even Information Technology earnings fell by 5.32% in the third quarter. However, even on the negative news, the S&P 500 gained 8.74% from September 30 through December 30. Information Technology, even after losing 5.32% in earnings the last reported quarter, gained nearly 14% from September 30 through December 30. This is the kind of activity that stretches valuations and makes portfolio managers nervous about the future.
A large contributor to 2019 financial market positives has been the ubiquitous supportive employment situation. The U.S. worker has enjoyed the benefit of unemployment remaining well below average, even for great economic times. The current unemployment rate sits at 3.5%, its lowest point in 2019, and personal income continues to outpace inflation. This situation keeps consumers happy, and a happy consumer makes for great news when almost 70% of economic production is generated by consumption as is the case in the United States. We believe as long as that continues, times should be good for investors. However, it seems a lot like playing king of the hill: When times are as good, you can only go down from there. For this reason, the attention of market watchers remains very closely fixed on the employment situation in a time like this.
By now you’re probably asking, “so what happens next?”—I’m getting there, but one caveat before making a call. The past three years have been anything but normal. Volatility in 2017 was non-existent, and the S&P 500 rewarded investors with a 21.88% return including dividends. Volatility returned in 2018 when I called for a 6% to 8% annual gain on the S&P 500. By the end of January 2018, I knew my forecast might be questioned as the S&P 500 had gained 7.54% in that first month. Little did I know the market would get slapped backward through mid-February to lose its gain, rebound through the summer and get beaten down again in the fourth quarter for an annual loss of 4.37% for 2018. Obviously, volatility in equity markets had not been solved. I made a similar call for 2019, a gain of 6% to 8%, but here we are with mere days left in the year and more than 30% higher. To my credit, if you were to combine 2018 and 2019, the overall price gain on the S&P 500 is 9.46%, only 1.46% above my annual expectation for each year. Needless to say, financial market forecasting is very difficult and can be a great source of humility, generally unwelcome humility.
On the negative side, valuations are at a 29.7% premium according to long-term average price-to-earnings ratio for the S&P 500; the election is very likely to get ugly, although impeachment has hardly moved the financial market needle; a trade war that is seemingly headed toward resolution; corporate earnings are seemingly slowing, and interest rates are not likely to decline in 2020. On the positive side—and these are strong positives—interest rates are low, employment is strong, wages are growing, and inflation is low. Ultimately, I am still stuck in valuation mode, which I generally struggle to avoid. That being the case, I find it hard to believe we will not revert to the mean P/E (around 16.6) at some point in the future, but it may be further out the horizon than 2020. I would be surprised if financial markets continue to give us gains while corporate earnings struggle. Fourth quarter 2019 earnings reports, which will begin in January, will tell us what to expect in the first half of the year. Given that long-term average annual returns on the S&P 500 using information back to the late 1920s show us a 10.5% average gain, I believe 2020 is likely to be below average. I believe the market could return half that and I would be happy, rounding to 5% for those who insist on a specific number is fine with me. Using a range to avoid any appearance of overconfidence in my forecast would put me at numbers between -10% and 20%, but who wants to hear that noise?
The difficulty in forecasting equity market returns in the short-term is an age-old problem. For that purpose, we have always touted the Henssler Ten Year Rule, whereby any assets needed for consumption within the next 10 years should be held in fixed income assets (bonds or CDs). Any assets not needed within the next 10 years should be held in stocks (aka equities) as they have proven to outpace inflation, therefore growing an individual’s wealth in the long run. This alleviates the need to “be right” when the market moves in one direction or another and stay invested, knowing history has shown us the long-run benefits of holding stocks.
I believe we could get serious spikes in volatility if the electorate decides on a presidential candidate who is unfavorable to business owners, and given early polling, that is a possibility. It should be fun to watch the market in months leading up to the election, as it has been a reasonable predictor for many election cycles. If you want to join the fun, look for a rising market to tell you the party in power will remain in power, while a falling market will indicate a new regime is likely to be ushered in.
Happy New Year!
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