Big Hopes For 2020 Ride On Earnings Growth And Capex Revival

As the New Year gets underway, stocks have continued their impressive march higher. Comparing the start of this year to the start of 2019 reveals some big contrasts. Last January, the market had just started to recover from a nasty 4Q18 selloff of about 20% (a 3-month bear market?), but this time stocks have essentially gone straight up since early October. Last January, we were still in the midst of nasty trade wars with rising tariffs, but now we have a “Phase 1” deal signed with China and the USMCA deal with Mexico and Canada has passed both houses of Congress. At the beginning of last year, the Fed had just softened its hawkish rhetoric on raising rates to being "patient and flexible" and nixing the “autopilot” unwinding of its balance sheet (and in fact, we saw three rate cuts), while today the Fed has settled into a neutral stance on rates for the foreseeable future and is expanding its balance sheet once again (to shore up the repo market and finance federal deficit spending (but don’t call it QE, they say!). Last year began in the midst of the longest government shutdown in US history (35 days, 12/22/18–1/25/19), but this year’s budget easily breezed through Congress. And finally, last year began with clear signs of a global slowdown (particularly in manufacturing), ultimately leading to three straight quarters of YOY US earnings contraction (and likely Q4, as well), but today the expectation is that the slowdown has bottomed and there is no recession in sight.

As a result, 2019 started with the S&P 500 displaying a forward P/E ratio of 14.5x, while this year began with a forward P/E of 18.5x – which also happens to be what it was at the start of 2018 when optimism reigned following passage of the tax cuts but before the China trade war got nasty. So, while 2018 endured largely unwarranted P/E contraction that was more reflective of rising interest rates and an impending recession, 2019 enjoyed P/E expansion that essentially accounted for the index’s entire performance (+31% total return). Today, the forward P/E for the S&P 500 is about one full standard deviation above its long-term average, but the price/free cash flow ratio actually is right at its long-term average. Moreover, I think the elevated forward P/E is largely justified in the context of even pricier bond valuations, low-interest rates, favorable fiscal policies, the appeal of the US over foreign markets, and supply/demand (given the abundance of global liquidity and the shrinking float of public companies due to buybacks and M&A).

However, I don’t think stocks will be driven much higher by multiple expansion, as investors will want to see rising earnings once again, which will depend upon a revival in corporate capital spending. The analyst consensus according to FactSet is for just under 10% EPS growth this year for the S&P 500, so that might be about all we get in index return without widespread earnings beats, although of course, well-selected individual stocks could do much better. Last year was thought to be a great setup for small caps, but alas the trade wars held them back from much of the year, so perhaps this will be the year for small caps. While the S&P 500 forward P/E has already risen to 19.0x as of 1/17, the Russell 2000 small-cap index is 17.2x and the S&P 600 is only 16.8x.

Of course, there are still plenty of potential risks out there – such as a China debt meltdown, a US dollar meltdown (due to massive liquidity infusions for the dysfunctional repo market and government deficit spending), a US vote for democratic-socialism and MMT, a military confrontation with Iran, or a re-escalation in trade wars – but all seem to be at bay for now.

In this periodic update, I provide a detailed market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings still look bullish, while the technical picture also is quite bullish (although grossly overbought and desperately in need of a pullback or consolidation period), and our sector rotation model retains its bullish posture. Notably, the rally has been quite broad-based and there is a lot of idle cash ready to buy up any significant dip.

As a reminder, Sabrient now publishes a new Baker’s Dozen on a quarterly basis, and the Q1 2020 portfolio just launched on January 17. You can find my latest slide deck and Baker’s Dozen commentary which provide discussion and graphics on process, performance, and market conditions, as well as the introduction of two new process enhancements to our long-standing GARP (growth at a reasonable price) strategy, including: 1) our new Growth Quality Rank (GQR) as an alpha factor, which our testing suggests will reduce volatility and provide better all-weather performance, and 2) “guardrails” against extreme sector tilts away from the benchmark’s allocations to reduce relative volatility. Read on....

Market Commentary:

Last January, I discussed the difficult 2018 climate in which no asset classes made money and the forward P/E for the S&P 500 fell from 18.5x to 14.5x, but I opined, I think we have been presented with a great buying opportunity, with perhaps 20-25% upside in the S&P 500 index during 2019, which would finally put the index above the 3,000 mark.”  Well, we actually got +31% total return from the S&P 500 last year, and in fact, it first surpassed 3,000 in mid-July.

I also wrote, “… it may finally spell a return to a more selective stock-picker’s market, with lower correlations and higher performance dispersion. Moreover, my expectation for 2019 is for a de-escalation in the trade war with China, a more accommodative Fed, and for higher stock prices ahead. Forward valuations overall have become exceedingly attractive, especially in the cyclical sectors that typically flourish in a growing economy.” As you know, all of that came to fruition – although it took until late August before cyclicals developed some solid traction.

While 2018 saw high asset correlations and nowhere to hide from the negative returns, 2019 also displayed high asset correlations but with all major asset classes going up – including cryptocurrencies, US large caps, US small caps, emerging markets (led by Brazil), global developed markets (even moribund Europe), gold (its best year since 2010), silver, palladium, oil, REITs, high-yield bonds, Treasuries, investment-grade bonds, and global bonds. The aggregate hedge fund return of the HFR Fund Weighted Composite index was up 10.4%, its best one-year performance since 2009. So, you could make money no matter where you invested, although the persistently high asset correlation is somewhat troublesome, making it harder for investors to diversify.

Notably, Apple (AAPL) alone was up +89% in 2019, while the Energy sector languished with a +6% total return, and as a result, AAPL now sports a larger market cap than the entire Energy sector in the S&P 500. Moreover, the top five companies by market cap in the S&P 500 – AAPL, Microsoft (MSFT), Alphabet (GOOGL), Amazon (AMZN), Facebook (FB) – now make up a record 17% share of the index’s total capitalization, which is the highest since the tech bubble. Notably, GOOGL joined the trillion-dollar market cap club on Friday, along with AAPL and MSFT (and AMZN made it their last summer before pulling back). Total market capitalization of US equities has reached $35 trillion, which is a record 1.55x US GDP of $22.3 trillion.

Largely driving the growing investor enthusiasm is a fading fear of a “late-cycle” economy on the verge of recession. In fact, it had become more of a self-fulfilling prophesy than a fundamental reality, and now investors are trying to ignore the fearmongers and move from risk-averse to risk-embracing, which better matches the fundamental outlook for the US economy and stocks, according to Sabrient’s model. My view has been that the economy is posturing more like recovery or expansionary cycle. In fact, I would argue that while the slow-growth post-Financial Crisis economy has managed to consistently print positive GDP growth readings, it was led by strong consumer spending supported by the “wealth effect” of asset inflation from a friendly Fed keeping the liquidity flowing. And looking under the hood, we can see multiple earnings recessions (during the mid-2014 through mid-2016 timeframe, as well as for the past few quarters), stagnant capital spending, falling industrial production, and a stark manufacturing recession. Furthermore, there have been some scary selloffs and what many consider to have been a brief bear market (-20%) in 2018.

Thus, I believe we may be in the early stages of a new expansionary cycle that might continue for several more years, including a manufacturing boom driven by new technologies like 5G, the Internet of Things (IoT), AI/ML, robotics, clean energy, oil fracking, blockchain, space travel, quantum computing, nanotechnology, genomics, and precision medicine. Notably, venture capital investment in artificial intelligence (AI) totaled about $18.5 billion last year, which was 10% more than in 2018.

The market is riding high on an accommodative Fed, subdued recession fears, newly signed trade deals, and M2 money supply growth. Investment grade corporate bond spreads have remained extremely tight. The consumer is strong and confident. Retail sales are on fire. US housing starts reached a 13-year high in December spurred by persistently low mortgage rates, and homebuilder sentiment is the highest since 1999. The BEA reported that the personal savings rate has stabilized above 7%, which hasn’t been seen on a consistent basis since the mid-1990s. The unemployment rate (U3) remains historically low at around 3.5%, and the seasonally adjusted U6 (which includes discouraged and part-time workers) hit an all-time low of 6.7%. Wages are rising, and the lower-income levels are seeing the greatest wage growth. A recent CNN poll showed that 76% of people think economic conditions are either “somewhat good” or “very good,” which is the highest percentage that poll has found since 2001. And yet despite the powerful rally, investors still seem mostly cautious about stocks. A record $135.5 billion was pulled out of U.S. stock mutual funds and ETFs in 2019, while margin debt sat at its lowest level since 2005. Moreover, $3.6 trillion sits idle in money market funds (which is up 24% over year-end 2018 and an amount not seen since the Financial Crisis) – potential fuel for a continued market rally.

In addition, corporate balance sheets are strong and productivity remains high. And although debt levels are on the high side, much of it is locked up at low interest rates, so debt carrying costs are around historical averages, and with a lower cost of capital, companies can generate better returns on invested capital (ROIC). In addition, both monetary and fiscal policy are working together to stimulate economic activity (rather than working against each other as was happening when the Fed began its tightening cycle in a “handoff” from monetary stimulus to Trump’s fiscal stimulus). The Fed has signaled no interest rate adjustments for the foreseeable future, and the Trump Administration continues to spend rather than cut while signaling a desire for additional fiscal stimulus in the form of a Middle-Class tax cut, further deregulation, and an infrastructure spending bill. According to Andrew Hunter of Capital Economics, “The stabilization in global manufacturing activity, and the trade truce with China, suggest that the drag on the US economy from weak growth overseas has now run its course.” I concur.

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