Monday, January 6, 2020

Will Volatility Greet Investors in the New Year?

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
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social shifts, yes, but they had nothing to do with “risk” and everything to do with the US population shedding outdated ideas.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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