Monday, January 6, 2020 - We wish our readers a Healthy
and Prosperous New Year! The Santa Claus rally extended into the first trading
day of the new year. However, news of the assassination of the Iranian General
Qassem Soleimani quickly put an end to the rally as investors woke up on Friday
to find a new reality in the Middle East and Oil Geopolitics. As we head into a
new week, investors find higher oil and gold prices and slumping markets in
Asia. Let’s see where this goes.
Looking at the markets, the major indexes closed out the year 2019
with the S&P 500 finishing up 28.99% and the Nasdaq Composite a respectful
35.2%. The broad market as measured by the S&P 500 closed the week at
3234.65. The NASDAQ Composite broke thru 9000 to close at 9020.77. Both indexes
ended the week largely flat due to Friday’s selloff but still had respectable
gains from November to the end of December.
Our readers will note that despite all the worrisome news headlines
we wrote during the year, returns were surprisingly great. The change in the
geopolitical oil markets got us thinking that investors are probably
underinvested in Energy, so we decided to reach out to our friends Nick Colas
and Jessica Rabe at DataTrek and get their view on 2020. Here is what they sent
us giving their views on corporate earnings, stock prices and global interest
rates. We strongly encourage you to check out a free trial at datatrekresearch.com
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2020
Market Outlook: Do’s and Don’ts
The
“Hemline index” is an old – but profoundly flawed – measure of societal risk
tolerance and, by extension, stock market valuations. It first
appeared in the Roaring 20’s flapper era and returned during the miniskirt age
of the 1960s. Lost on those who created the measure: the fact that US
women finally got the right to vote in 1920 and that the 1960s generation
embraced gender rights more than any previous cohort. Changing hemlines
signaled social shifts, yes, but they had nothing to do with “risk” and
everything to do with the US population shedding outdated ideas.
Now,
investing does of course have its “fashions”. Tech stocks come in and out
of vogue. Small caps can occasionally be the “new black”. And who
among us has not been tempted to pick up the latest creation from the investment
houses of Blackrock, Vanguard and State Street? Even when our portfolio
closet is already full…
In
that vein, we’ll borrow from the front pages of Elle, Vogue and Cosmo to offer
up our top “Dos” and “Don’ts” for investing in 2020:
Do:
Understand that US equity valuations are toppy just now and expectations are
high for 2020.
The
S&P 500 trades for 18.3x forward year earnings according to FactSet’s
latest analysis. That compares unfavorably to a 5-year average of 16.7x
and a 10-year average of 14.9x.
FactSet
also notes that Wall Street expects the S&P 500 to post 9.6% earnings
growth in 2020 after no growth in 2019. On the plus side, that does give
2020 the benefit of easy comps. But
we’re in the camp that believes earnings growth will be more like 5%, and
loaded in the second half of the year.
US
small cap equities are not much cheaper: the S&P 600 trades for 17.8x
forward year earnings and the Russell 2000 goes for 25.4x. (Source:
Yardeni Research)
Don’t:
Anchor off 2019’s 29% price gain for the S&P and assume it means anything
about 2020.
First,
remember that 2018 was a tough year, down 4.2% on a total return basis for the
S&P. Therefore, the 2-year compounded annual growth rate for the S&P
for 2018-2019 is just 12%, not far from its 11.1% 50-year CAGR.
Going
back to 1928, there is only 1 example where a large up year (+25%) was then
followed by a dramatic down year. That was in 1936 (+32%) and 1937 (-35%)
during the second phase of the Great Depression.
S&P
returns of 25% or greater are not even that uncommon; they have occurred in 25%
of the years since 1928.
The
average return in the year after the S&P posts a +25% gain is still
positive 10%.
Bottom
line: US stocks are expensive, but we should see enough earnings growth to see
the S&P 500 rally by 10% this year.
Do:
Embrace rising global interest rates in 2020.
Low
long-term rates were the cause of the mid-year 2019 global recession
scare. German 10-year bond yields troughed in late August at -0.72% and
US 10-year Treasuries at 1.5%.
The
causes: a US-China trade war that had ground the German economy to a halt,
combined with still sluggish economies in France, Italy and Spain.
The
market feared this slowdown would spill over to the US. Both
30-day/10-year and 2-year/10-year Treasury spreads went negative, elevating
concerns that these time-proven recession indicators augured tough times
ahead.
With
the US and China set to sign a Phase I trade agreement later this month, global
economic uncertainty should ease in 2020. This should keep global rates
moving higher.
Don’t:
Assume the Federal Reserve is done cutting rates.
Yes,
the latest Fed Dot Plot shows a remarkable level of agreement among FOMC policy
members that short rates will remain unchanged in 2020.
But
September 2020 Fed Funds Futures are pricing in a 50/50 chance of a rate cut
next year.
The
issue: even with the US economy running strong, the Fed’s favored measure of
inflation (core PCE) is only up 1.6% over the last year. Moreover, core
PCE has only met the Fed’s 2% target in 11 months over the last 10 years…
Bottom
line: bonds are unlikely to post anything like 2019’s positive returns in 2020. For yield
sensitive investors we recommend shortening duration modestly.
Do:
Understand the important sector differences and fundamental drivers between
seemingly analogous equity index investments:
With
Tech’s outsized gains in 2019, the S&P 500 is very heavily exposed to this
industry group. Tech plus Amazon (in Consumer Discretionary), Google and
Facebook (in Communications) is now 31.2% of the S&P 500. Even energy
in the late 1970s/early 1980s never got to those levels…
By
contrast, the Russell 2000 is heavily exposed to politically sensitive Health
Care (18.0%), yield curve exposed Financials (17.5%) and trade war influenced
Industrials (15.9%), with Tech just 13.8% of the index. Also, since a
third of Russell companies are unprofitable, access to/cost of junk debt
capital is a critical valuation driver.
Spreads here are historically tight, with not much room for improvement
in 2020.
The
MSCI EAFE index of European/Japanese stocks has just 7% exposure to Tech; the
heavyweights here are Financials (18%), Industrials (14%) and Health Care
(12%).
The
MSCI Emerging Markets index actually looks more like the S&P 500, with Tech
plus Alibaba (Consumer Discretionary), and Tencent/Naspers (Communication) at
26.4% of the index. Financials are a large component as well, at 22%.
Therefore
Don’t: Think EAFE or Emerging Markets are “cheap”.
Yes,
both EAFE and EM stock indices are cheaper than the S&P 500, at 14.8x and
12.8x forward year earnings respectively. (Source: Yardeni Research)
But…
the S&P has (as noted) a much heavier concentration of US Tech stocks, with
a proven track record of innovative disruption and long run growth.
Apple, Microsoft, Google, Amazon and Facebook are collectively 17.0% of the
S&P 500.
While
EAFE has no such Tech concentration, the MSCI Emerging Markets index does, and
it is anchored around Chinese Tech. Alibaba and Tencent/Naspers are
collectively 11.5% of EM.
The
MSCI Emerging Markets index is heavily weighted to China (32%), Taiwan (12%)
and South Korea (12%), collectively 56% of the total.
A
directionally correct oversimplification: the S&P 500 is a global
(ex-China) tech index, EAFE is non-Tech cyclicals, and EM is China (especially
Chinese Tech).
Bottom
line: we continue to favor US large caps over any other equity asset
class.
Do:
Vote if you are a US citizen, but Don’t: Worry about the election informing
stock prices.
The
US economy is doing well enough that the Democratic nominee will likely be a
centrist rather than from the left wing of the party.
That
will make the 2020 US Presidential election more about personalities than
economic ideas. If we’re wrong about the prior point, markets will
rightly assume that the Democratic candidate will have a very tough time
winning the general election.
Until
November, you can safely expect President Trump to do everything possible to
keep the current economic expansion going. That includes signing a Phase II
trade deal with China in time to help with his reelection campaign.
Bottom
line: the 2020 Presidential election will be close, but markets will be able to
live with either candidate.
Do:
Expect the unexpected, but Don’t: Panic.
Recent
Middle East events are a good example. The S&P 500 was down all of 71
basis points on Friday despite the news out of Baghdad.
Incremental
US oil production over the last 10 years has fundamentally shifted industry
economics in favor of lower structural prices. Don’t forget: since 1970
the US has never seen a recession without oil prices first rising by 90% within
a year.
Bottom
line: no doubt 2020 will bring other curve balls, but in the end we believe US
and global equity prices will end the year higher and rates will remain
low.
Thank you for reading the ETF Global Perspectives!
_______________________________________________________
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