earnings vs prices
In 2019, U.S. based large cap stocks, as measured by the S&P 500, produced a generous total return of 31.49%. Over the last 30 years, the S&P 500 has returned more than 30% only five times or 17% of the time. The average annual return for stocks in the last decade, beginning January 1, 2010 was a heady 14.1%, the only down year being 2018. The average for the prior decade, beginning January 1, 2000 was only 1.2%, with four down years and staggering price drops in 2002 and 2008.
Last year at this time, stocks had just taken a precipitous year-end nose-dive to end the year down 4.4%. Stocks were oversold and the PE multiple was relatively low; the Federal Reserve had raised interest rates the fourth and final time December 20th. A lot of investors were disheartened by the rate hikes and on their heels when the market sentiment turned in early 2019, causing them to miss some of the upturn.
Today, the market is regularly making new highs. The Federal Reserve opted to reverse its 2018 rate hikes with three cuts in 2019. This drove animal spirits that were wrestling with negative fallout from the trade war and slowing growth around the globe. One argument is that the Federal Reserve, bullied or not, became the only adult in the room.
Now, at 18.2x expected 2020 earnings, stocks are more expensive than a year ago. According to JP Morgan, the 25-year average is 16.3x. Just how pricy the market is, of course, is contingent on multiple factors – during those 25 years, stocks have sold for over 24x, and below 10x. FactSet currently estimates $178 per share in earnings for 2020, a nice 9% bump from the $162 companies in the S&P 500 managed for 2019.
My biggest concern for the coming year is a protracted deterioration in our economic relations with China. The U.S.’s self-declared war on trade is now two years old and the loser in the trade war has been the American consumer, forking over billions of dollars in tariffs to no effect. Trade wars are clearly not good or easy. The economy and the stock market will both be better off once there is resolution. In my opinion, the U.S. has been busy wasting time and money in the Middle East, while China has been investing, and building diplomatic and economic relationships around the world. Bullying the Chinese will not help the American economy.
Earnings will prove key to stock prices this year. This may seem obvious, but last year earnings were flat, while stock prices skyrocketed. This jump was due entirely to PE multiple expansion, which in turn was driven by the reduction in interest rates. The Federal Reserve cut rates three times in 2019, and that is unlikely to happen again in 2020. So, if stock prices are to rise this year, it will hinge on improved corporate profit margins and earnings per share.
Our energy is directed at selecting quality U.S. stocks and bonds where we have reliable information. We make active bets on companies we believe from a fundamental and a quantitative perspective are positioned for price appreciation. Stocks and bonds, our asset classes of choice, are reliably non-correlating, counter-balancing each other’s volatility. We manage our bets, and the overall exposure to risk, in each portfolio. This is in distinct contrasts to the use of multiple asset classes, deployed via mutual funds and ETFs, as is the common practice among many investors.
For 2020, I expect the markets will likely behave a lot like they did in 2019, until November. Then, we shall see. In the meantime, we will continue with our emphasis on growth stocks. This tilt has enabled strong performances from our primary equity models over the last several years. If it begins to look as though the expected 9% bump in earnings is not going to come to fruition, we will re-assess and modify our approach. Until then, stocks (even slightly more expensive stocks) remain the best bet. We look forward to getting together with you in the New Year.
Bruce Hotaling, CFA