Stellar Year For Stocks Now Suggests Strong Follow-Through In 2020

Investor sentiment continues to rotate risk-on:

As I have been discussing for months now, a stark market bifurcation commenced in June 2018 favoring secular growth, low-volatility and momentum factors, “bond proxy” defensive sectors, and large caps (i.e., late-stage economic cycle behavior) over cyclical growth, value and high-beta factors, cyclical sectors, and small-mid caps (i.e., expansionary cycle behavior). It persisted longer than the analyst consensus used in our GARP model suggested, with only fleeting glimpses of risk-on rotation whenever promising news about the trade war came out. Until 8/27/19, the risk-off defensive sentiment was dominating, and it was worryingly looking a lot like deja vu from last year. As you recall, at about the same time last year, small caps peaked on 8/31/18 while the S&P 500 was able to march a bit higher before peaking on 9/20/18, but it was doing so on the backs of defensive sectors along with secular-growth Tech mega-caps, and I was opining at the time that the rally would fizzle if there wasn’t some rotation into the risk-on cyclicals and small-mid caps – which as you know didn’t happen, leading to the Q4 selloff.

But, happily, this year has played out quite differently. On 8/27/19, instead of peaking and selling off like last year, stocks put in a bottom and rallied hard for a few weeks, then pulled back to test bullish conviction, and then resumed the uptrend. Importantly, a risk-on sentiment has been driving the rally, and that historic divergence of low-volatility/defensive/large-cap overvalue/cyclical/small-mids continues to converge, as investors have become optimistic about at least a partial resolution to the trade war (including the lifting of tariffs before the 12/15 deadline), a dovish Fed, an improving outlook for 2020-21 corporate earnings, and resurgent capital investment.

Looking at 2019 performance, all major asset classes are up – as compared to all being down last year. So, asset correlation continues (which makes it harder on financial advisors to diversify). In rough numbers as of the end of last week, global equities were up over +22% YTD, commodities +15%, high-yield corporate bonds +12%, investment-grade corporate bonds +11%, government bonds +5%, and the US dollar +2%.

Interestingly, if we look back to the last presidential election in 2016 and compare the relative performance of the SPDR S&P 500 (SPY) versus the top-performing Technology Select Sector SPDR (XLK) and worst-performing Energy Select Sector SPDR (XLE), you can see that Energy jumped out of the gate immediately following the election (given Trump’s pro-domestic energy stance), but then quickly reversed and has struggled ever since. On the other hand, Technology overall has thrived, although it was mostly driven by the mega-cap juggernauts like Microsoft (MSFT) and Apple (AAPL) rather than a healthy breadth. In addition, I have plotted the iShares 20+ year Treasury ETF (TLT), which illustrates how correlated it has been with the SPY over the past two years.

SPY-XLK-XLE-TLT

Earnings, GDP, and interest rates:

As for corporate earnings, Q3 reporting proves that Corporate America actually has been quite resilient despite the trade wars. And looking ahead, according to FactSet, analyst consensus for the S&P 500 in 2020 is 5.5% revenue growth and 9.7% EPS growth (specifically, $162.81 EPS in 2019 growing to $178.57 in 2020), with the strongest growth coming from Energy, Industrial, Materials, Consumer Discretionary and Communication Services sectors. At Thursday’s closing level of 3,168 for the S&P 500, that computes a 17.7x P/E multiple and a 5.6% earnings yield (plus a dividend yield of 1.75%), which seems quite reasonable compared with a 10-year Treasury yield around 1.8%. According to DataTrek, for the S&P 500 to achieve that forecasted growth, over 50% of the index by market cap (comprising Technology, Comm Services, Consumer Discretionary, and Industrial sectors) must see the 0% average EPS growth in 2019 rise to 13% growth – which pretty clearly depends upon some resolution (at least a Phase 1) to the trade war.

As for US GDP, following growth in Q1 of +3.1% and Q2 of +2.0%, the BEA’s second estimate for Q3 2019 is 2.1%. Looking ahead to Q4 estimates, the Atlanta Fed’s GDPNow model predicts +2.0% GDP growth (as of 12/6) and the NY Fed’s NowCast sees +0.6% (as of 12/6), while the St. Louis Fed NowCast sees a more optimistic +1.9% (as of 12/6).

The 30-year Treasury yield closed Thursday at 2.31%, while the 10-year T-note closed at 1.90%, the 2-year T-note 1.66%, and the 3-month T-bill 1.56%. So, the 3-month/10-year spread is at +34 bps, while the more closely followed 2-10 spread is at +24 bps, as the Fed has restored confidence among fixed-income investors by committing to purchase Treasury bills and shore up the repo market, thus pushing down short-term rates. Its efforts have also restored confidence among equity investors, enticing capital rotation out of longer term bonds and into equities, helping to “un-invert” the yield curve, which (as I have frequently opined) was artificially inverted due to defensive global investor sentiment and low rates overseas rather than for fundamental reasons (like an over-heated economy or rising inflation). The US continues to pay much more lucrative yields compared with other developed markets, and in fact, Germany, France, and Japan continue to offer negative rates across most of the yield curve (i.e., you have to pay them for the honor of holding their bonds).

In the FOMC announcement on Wednesday, it was made clear that there is now unusual consensus among the governors to keep the benchmark rate stable in the current 1.50-1.75% range for the foreseeable future. Nevertheless, CME Group fed funds futures are showing 24% probability of another 25-bp rate cut by June, rising to 50% by December 2020, and zero chance of a rate hike next year.

Looking ahead:

We may well see a correction next year to test bullish conviction at these new highs, but there is no recession in sight, especially when you also consider that Q3 earnings turned out much better than expected even though businesses have been holding back on capital spending until they have greater visibility vis-à-vis the trade war. One can only imagine the kind of boost we might see from resurgent capital investment. Tailwinds for 2020 include ongoing monetary stimulus (low-interest rates and easy access to credit), ongoing fiscal stimulus (low tax rates and deregulation), record low unemployment, low inflation, lofty consumer confidence, improving business confidence, and fatigue setting in among the combatants in the trade wars. Moreover, real interest rates in the US are negative (which is historically bullish) and both the ECB and Federal Reserve are cutting rates at the same time, helping to steepen the yield curve. In addition, there is plenty of idle cash still on the sidelines, and although investor confidence is growing more optimistic, most investors are still far from “exuberant.” Instead of a recession, I think we are likely to see a continued rotation out of wildly popular growth/momentum stocks of recent years and into the vast sea of overlooked names (especially many in the small and mid capitalizations) that still sport attractive valuations.

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Disclaimer: Sabrient's newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into ...

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