This was our comment to clients at the end of 2018. “A solid U.S. economy and healthy corporate profits remain at the foundation of this market which has been temporarily hijacked.” Our expectation was that the worst was largely over and when companies started reporting in the middle of January (2019), sentiment should begin an upward trajectory. Over the last year, the broader markets have come back strong and we will place the strength of 2019 into perspective.
Equity valuations have rebounded from 2018’s year-end major sell-off.. While 2019 was a strong year for those who were fully invested in stocks, it was not without its challenges. Currently, the full year 2020 P/E ratio for the S&P 500 stands at 17.8 times on a base on earnings of $180. Last year, this ratio stood at 14.5 times. This forward P/E ratio is above the 5-year average of 16.6x and the 10-year average of 14.9x. Earnings expectations for 2020 are solid at high single digit levels and we believe therefore support the current valuation levels. Since inception, which dates to the late 1920s for the S&P 500, the compound annual growth rate is approximately 6% and over the last 15 years, the rate is closer to 7%.
Since we have also entered a new decade, we will briefly reflect upon some of the major changes over the last decade. From our perspective, several major changes during the last decade that will have lasting influence on society included: the gig economy, renewable energy, cloud storage, as well as content and membership revenue models. What is a gig economy? It evolved from a work project rather that a salaried position for a length of time. In 2010, would we even contemplate getting into a car driven by a stranger or possibly renting a stranger’s house or room for a night or a week? What about the US exporting oil and becoming energy independent? Of course, technology has played a huge role to enable and propel the gig economy, U.S. energy independence, as well as the choices to subscribe to Amazon, Netflix, Disney, Comcast and more for the annual or monthly content and value membership propositions such as hourly or overnight free shipping.
The conventional perspective for 2020 is that the economy may continue to slow, pressuring earnings and keeping a lid on stock prices, but what if the economy grows more than expected? What if the tariff war continues to abate? What if Europe makes progress and turns around even a small amount? What if negative rates in Japan and Germany follow Sweden’s lead and move to zero and ultimately return to positive territory? And what if more sizable countries begin to grow and drive global growth higher than the IMF’s forecast of 3.4% in 2020?
Our market perspective remains centered upon the strength of individual companies and the health of the U.S. consumer. Corporate balances sheets, and income statements are strong and consumer sentiment is positive. The historically low unemployment rate is to thank for the healthy consumer sentiment. For the first time, in a very long time, wage growth has returned with some consistency. While wage growth is low single digits, it is still better than it had been in the past several decades. Prolonged low unemployment rates for the longest time did not translate into noticeable wage growth. This dynamic change along with skilled labor shortages will continue to fortify consumer sentiment. It is just common sense that when the consumer feels good about their current job as well as the possibility that if they lost their job, they could find another one of equal or greater pay, then, GDP should remain steady to rising in 2020, since nearly 70% of U.S. GDP is fueled by the consumer.
US companies continue to payout record dividends which is an indicator of strength. Companies in the S&P 500 are expected to return nearly $480 billion in dividends to shareholders in 2019 up from last year. These dividend payouts are the latest shareholder benefit due to the strength of company profits and cash flow. The solid underlying dividend strength is particularly impressive given the very low returns associated with government bonds.
Currently, the ten-year US Treasury bond yield stands at 1.93% versus 2.74% a year ago and is well below the dividend yield of many blue-chip companies. For comparison purposes the S&P 500 yield stands at 1.8%. Analysts are forecasting another solid year for dividends in 2020 as they are projected to increase by as much as 6% which is the average annual advance over the last ten years. The Federal Reserve continues to be a source of liquidity for the market, adding more than $400 billion through short term repurchase agreements over the last few months.
Strong balance sheets and healthy corporate earnings are necessary to Support the corporate dividends and merger and acquisition pace. As reported during third quarter 2019 earnings season, 75% of the companies reported positive earnings per share surprises and 60% reported better than expected sales surprises. Fourth quarter and year-end earnings will begin in approximately three weeks and expectations have moved modestly lower, although they are still solid. We expect more upside surprises which we have seen for the last three consecutive quarters. This year, corporations have been challenged as the corporate tax benefit of 2018 became a headwind in 2019, plus, the tariffs presented both revenue and expense hurdles. Further, while the U.S. consumer is strong, they are discerning. Just-in-time inventory has been elevated to same-day delivery. Consumer drone delivery is not too far into our future.
Our 2020 vision is based on a strong team with years of experience researching stocks and bonds. We remain focused on our macro themes and drill down into investments that will provide the benefits to our clients. Each year there is a lot of noise that could potentially distract people from the core long term trends. What do we expect in 2020 and over the next few years? Here are a few of our thoughts and insights:
The Fed will keep interest rates flat in 2020 and possibly lower them once. The mission of the Federal Reserve is to foster the stability, integrity, and efficiency of the nation’s monetary, financial, and payment systems so we expect rates to remain stable in 2020. Last year, we forecasted that rates would not be increased and while that may not appear too insightful at this point, at this time in 2018, it was unconventional when we made that call. In 2019, the Fed cut rates three times for a total of 75 bps and currently stands in a range of 1.50%-1.75%. There is a potential case for further easing in 2020, given the trade tensions and lack of global growth.
Many believe the Fed will not adjust interest rates during US presidential election years, but our research shows that there have been changes historically, but the Fed is unlikely to pivot in a new direction during an election year. Treasury yields should remain low and the yield curve should remain modestly, positively sloped. Chairman Powell was suffering from a lack of credibility last year and while he remains at the helm, there has been a shift to more accommodation and dovishness and his communication skills of messaging has improved. There are some changes to the board of the Federal Reserve, and this will bring a large dove to the table, namely Neil Kashkari.
Holding Firm on Trade. The back-and-forth public trade negotiations with China and other neighboring countries brought much volatility to the broader markets in 2019 and as we open 2020 there is a deal on the table and the markets appear to be satisfied. In this phase, tariffs are no longer being levied, and we expect China to cut some of its tariffs on products in first quarter 2020. We do expect more phases to be rolled out over the next few years. We believe, ultimately, there will be an improvement and China will be held to a higher standard by the rest of the world, not only the U.S.
India in focus. India will continue to grow as a world economy. We think the U.S. trade policy of making more unilateral trade agreements means India will be in focus as a strong ally of the U.S. in many ways. The U.S. is India’s largest trading partner followed by United Arab Emirates, China, Hong Kong, Singapore and the UK. The country’s enormous population, second to China with more than 1.4 billion people, is projected to outpace China over the next decade, has favorable demographics and is a country to be watching closely. India’s consumer market, places about seventh, just behind the UK and is comprised of a sizable middle-class population.
IPO Activity to remain strong but more selective. The companies coming to market in 2019 raised approximately $46 billion, falling shy of the projected blockbuster amount of $60B but steady with the prior year’s capital raise. Even with the casualties of the IPO market such as Uber, Lyft, and Pinterest, the average return for this group stood at 20%. Remember that many of the companies coming to market have earnings and several years of operating history which is a strong positive. It would be ridiculous not to mention the train wreck of WeWork in this IPO narrative and we were surprised that this story was brought to the broader market. We think this was a good thing, because the average investor just assumes anything brought to market as an IPO is a good investment to get into at the ground floor. Often, we find it is better to wait and let a stock settle before investing. Some of the names in 2019 such as Uber are good examples of why it pays to be patient to find an entry point. This year, we expect the IPO pipeline to remain healthy with modestly more companies testing the direct listing path which means a company lists stock on its own for sale in order to give current shareholders a liquidity event. The direct path to market does not raise new funds nor use underwriters but, provides liquidity to the existing shareholder base. The most notable companies that utilized the direct listing method recently include Spotify and Slack. We expect this path to the market to build momentum over the next several years.
M&A activity is likely to pick up. There are so many changes taking place in society due to technological improvements and new trends that we think its inevitable we will see a pick up of merger activity in 2020 as the weak get bought out or the strong decide its time to enhance their business even fast using an acquisition strategy. We think the “streaming media” category is likely to start to see some companies be acquired as that entire industry solidifies and consumers become more discerning. We are currently looking for ways to leverage our short- and long-term view in this area.
5G begins to take hold. Many companies talk about what they are doing in 5G and specific geographies throughout the US are being wired for 5G, but it is still in its infancy stage. We expect to finish the year with niches of 5G experiences that will WOW the markets. It will take several years for 5G to being rolled out with enough magnitude to make its mark in multiple sectors of the global economy, and it will be worth the wait.
Volatility is here to stay. Volatility did return in 2019 and we expect it to stay engrained in the market throughout 2020. The good news is though, we’re used to it by now! The long-term average VIX (volatility index) value is 19 (the higher the number the more volatility) and most often the value is 12. In 2019, the trading range was 29 – 11. Since April 2009, the VIX has not traded at 50 or above. We expect volatility to be in a normal range, within 12 to 20 and potential spikes as we move through the presidential cycle, trade tiffs and global unrest. The VIX is an index that we pay close attention to in order to gauge when we may be due for a strong “updraft” or “downdraft” temporarily. We enter 2020 with confidence and a strong educated prediction that by the end of this year the markets will be moderately higher, up 6%-8%. The underlying corporate and consumer positives continue to outweigh the negatives. As you know we regularly post market commentary and it is important to remember that these are short-term views as we customize respective asset allocations to the individual’s time horizon and risk characteristics. We thank you for your continued faith and trust in us.
The Bell Rock Team wishes you a new decade and new year full of happiness, health and prosperity.