Investors would like to forget 2018. Higher rates, bigger tariffs and slowing growth all came together to create a whirlwind for stocks in the back half of the year. From October to the end of the year, stocks dropped about 20%.
But, the New Year could bring new hope.
Entering 2019, the S&P 500, Dow Jones Industrial Average and Nasdaq Composite are all still in correction territory. But, they’ve all shown signs of life to end 2018, too. While all of the major indices were at some point either flirting with or in bear market territory in December, none of them are in bear market territory anymore. Indeed, since bottoming on Christmas Eve, all three major indices have risen nearly 6% or more to end the year.
This is more than a head-fake. There are many reasons to believe this upward momentum will sustain itself in early 2019.
What are those reasons? Let’s take a deeper look.
Lowest Valuations Since 2012
Data Source: S&P Global
The late 2018 plunge in the S&P 500 has happened without anything showing up in the fundamentals. That is, while the S&P 500 dropped nearly 20% to end 2018, earnings didn’t fall at all. Instead, they kept rising.
The net result is that the S&P 500 in now trading at just 16X trailing earnings. That is the lowest trailing P/E multiple the market has had since late 2012, and it is also well below the historical median trailing P/E multiple of over 18.
Thus, broadly speaking, stocks are “on sale” right now. Unless earnings growth falls out and/or the U.S. economy plunges into a recession, stocks should rally from today’s depressed valuation levels to more historically normal levels of around 18X trailing earnings. Such multiple expansion plus even tepid earnings growth gives stocks ample firepower to run higher.
Economic Fundamentals Remain Healthy
Image Source: Cleveland Fed
Broadly speaking, the U.S. economy at present remains largely healthy. The unemployment rate remains at multi-decade lows. Jobless claims volume continues to fall. Wages are rising. Inflation is under control. Business and consumer confidence and sentiment remain robust. The yield curve hasn’t inverted where it matters. Recession likelihood within the next 12 months remains well below where it was leading into prior recessions.
In the big picture, the U.S. economy remains healthy. This is most broadly seen with real GDP growth. Real GDP growth is 2.5% and climbing. It might cool next year, but not to the extent that it has cooled heading into prior recessions.
The most likely outcome going forward is slower growth, but not negative growth. Slower growth coupled with below-average valuation levels should produce healthy returns for equities from current levels.
Earnings Growth Forecasts Are Strong
Image Source: FactSet
Largely due to still healthy economic fundamentals, Wall Street analysts are projecting healthy earnings-per-share growth in 2019. According to FactSet, corporate earnings are expected to rise around 8% next year. That is much slower than the rate the market has seen over the past two years. But, this simply looks like reversion to the mean growth rate after two years of super-charged earnings growth.
Reversion to the mean should produce strong returns for stocks. From 2012 to 2016, corporate earnings growth was stuck in the 5% and below range. That tepid earnings growth coupled with a trailing price-to-earnings multiple that hovered between 14 and 18 led to the S&P 500 rising 80% between the start of 2012, and the end of 2016.
Now, we are reverting back to mid- to high-single-digit-earnings growth, while the market is trading around 15 trailing earnings. That combo draws strong parallels to the dynamic the market had from 2012-16, when it rallied 80%. Thus, so long as mid- to high- single-digit-earnings growth persists, stocks should head materially higher from here.
Everyone on Wall Street Is Bullish
Image Source: Factset
Given below-average valuations, still healthy economic fundamentals and still strong EPS growth forecasts, pretty much everyone on Wall Street thinks stocks will rally in 2019. According to FactSet, the consensus price target for the S&P 500 in 2019 is 3,150. That represents more than 25% upside from current levels.
Granted, investors shouldn’t take Wall Street analyst opinion as fact. But, there is something to be said for this group being bullish in 2019. Over the past decade, Wall Street year-end price targets have overestimated the actual year-end finish of the S&P 500 by just 2%, on average and excluding 2008. Moreover, whenever they overestimate the price target in a year like they did in 2018, the next year’s estimate tends to be very accurate.
Overall, Wall Street analysts see the market rallying 25% in 2018. That’s a big rally. It may not happen. But, the broad takeaway is that at current levels, there are plenty of reasons to be optimistic about 2019’s return potential.
We Avoided the Bear Market
Image Source: Bespoke
All the headlines said that the S&P 500 dropped into bear market territory. But, those headlines need some clarification. On an intra-day basis, the S&P 500 did drop 20% off its highs. But, on a closing price basis, the S&P 500 did not. On Dec. 24, the S&P 500 closed 19.8% off its September high, and has since bounced back.
From this perspective, the market narrowly avoided a bear market. That’s great news. According to Bespoke Investment Group, there have been five near bear markets since 1950. Of those five near bear markets, only one of them has been accompanied by a recession. The other four were simply downward corrections that ultimately resulted in stocks rebounding.
Thus, the fact that the S&P 500 narrowly avoided a bear market is historically significant. At this point in time, history says there is no recession coming, and that stocks should rally in 2019.
Headline Risks Will Abate
Data Source: CNBC
There are two big risks to the stock market right now. First, you have the Fed tightening after a decade of accommodating monetary policy. Second, you have escalating trade tensions between the U.S. and China. Both of those seemingly came to a head in 2018, with the Fed hiking four times and calling for more hikes next year, and no tangible resolution being reached between the U.S. and China.
Yet, there is a considerable chance that these risks back off in 2019. First, the Fed isn’t blind. They see the stock and bond markets essentially signalling that too much tightening will lead to a recession. They also see the economic data cooling off and inflation coming down. Thus, it’s likely they don’t hike at all next year. If so, markets will rally.
Second, both the U.S. and Chinese stock markets and economies are starting to feel real pain from this prolonged trade war. When both sides in a negotiation start hurting, that is usually when resolutions are made. This seems especially true for U.S. President Donald Trump, who has tied his success with the success of the stock market. Thus, recent turbulence in the markets will likely make Trump more willing to reach a resolution with China. If such a resolution is reached, markets will rally.
The Return Profile for Stocks Is Attractive
Data Source: S&P Global
At current levels, the long-term return profile on stocks is quite attractive. Since the 1980’s, corporate earnings have followed an exponential growth trend-line. We are currently above that trend-line, so a near-term pull-back seems rationale. But, according to that trend line, S&P 500 EPS should hit $210 by the end of 2025. That represents about 3.7% earnings growth per year from the end of 2018 to the end of 2025.
Meanwhile, the current trailing earnings multiple is 16. The median multiple since the 1980’s is 18.1. Assuming valuations normalize by 2025, that implies roughly 1.8% of multiple expansion per year over the next seven years. Also, you have to add in the market’s current 2.1% dividend yield.
If you add all that up (3.7% earnings growth plus 1.8% multiple expansion plus 2.1% yield), you are looking at potential long-term equity returns of 7.6% per year. The current 10-Year Treasury yield sits at just 2.7%. Thus, it seems like choosing stocks over bonds here is a very obvious choice.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.