As 2019 comes to a close, the list of surprises has been growing. Most market prognosticators were not predicting a 25%+ move in US equity markets given the backdrop of trade conflict and a slowing global economy. When the Fed shifted toward accommodation at the beginning of the year, the market followed suit, but it has been a bumpy ride.
My previous updates have pointed out that most of this year’s return has come from P/E multiple expansion rather than earnings growth. As of yesterday, the S&P 500 forward P/E ratio stands at 18x (with trailing P/E at 19x) versus 14.4x at the beginning of the year. While we are higher than the 25-year average P/E ratio of 16.2x, we are not even close to what can be considered “nosebleed territory” at present.
Our investment team had an intense debate over valuation in our recent 2020 Strategy Summit, with the group divided over how relevant P/E ratios are right now. With rates still hovering slightly above historic lows and the Fed poised to add liquidity in response to weakness, there is still really no viable alternative to equities. The case for continued multiple expansion is further bolstered by the amount of cash still on the sidelines: A combined $4 trillion (including private equity dry powder) needs to find a home somewhere.
Where does that leave us when we look into the crystal ball for 2020? Clearly, earnings growth needs to expand from its moribund pace this year. The Street is expecting somewhere in the neighborhood of 6%, which seems achievable given easier year-to-year comparisons, continued buybacks, and this initial Phase I China trade deal. History is favorable for stocks in an election year (only four out of the last 23 have seen negative returns) and market performance after three Fed rate cuts followed by a pause is historically also very positive. Liquidity is ample, technical signals are positive, the economy seems to be perking up a little, the U.S. consumer is strong, the world economies may be lifting off a bottom. What kind of return should we expect in 2020 and what are the risks out there? High valuations just don’t seem to be enough to force us to reduce risk at this point.
From a market volatility perspective, we still think full confirmation and execution of a China trade deal is front and center. The market has been fixated on handicapping this event and most gyrations this year have come from murky and conflicting headlines regarding the progress. A single tweet can add or subtract $500 billion from global market cap in a matter of minutes, with both sides posturing but pushing for a Phase I resolution. In the worst case, we get an extension of tariff deadlines, while the best case is a deal with some teeth. What is crystal clear is that the market is pricing in a positive outcome and anything different will likely force a selloff.
There is some chatter about structural problems in the repo market that are unresolved and destabilizing. The overnight repo borrowings from the Fed (which some have described as QE4) have been hovering north of $200 billion, and nervousness comes from the fact that it’s not abating. There is discussion by the FOMC about keeping a standing repo facility in place, which would be unprecedented.
Domestic political risk is hard to handicap and best left for an update later in the year when we have more clarity on the election. The same applies to geopolitics, with several chronic hot spots bubbling but not rising to imminent high risk levels on the probability scale. As mentioned above, valuation shouldn’t hold the market back and the Fed should be mostly on the sidelines unless we see renewed economic stress.
In regards to portfolio strategy, we have added a gold allocation to our alternatives fund and reduced real estate exposure. Within equities, we continue to favor the wireless “5G” space, which should be transformative for companies in multiple industries as the new networks become a reality over the next three years and beyond. We are constructive but cautious moving into 2020.
Please contact me with any questions via phone at 804-774-2087 or email at Jesse.Ellington@MiddleburgFinancial.com.
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