The Grinch had the upper hand during the last quarter of 2018 but it was Santa’s (or Hanukkah Harry’s) turn in 2019. During the last three months of 2018 the S&P 500 lost 13.5%, in contrast the S&P 500 gained 9.1% this past year. In all, the full year of 2019 was very strong with the S&P 500 gaining 31.5%, its largest gain since 2013 when the average gained 32.4%.
The Federal Reserve raised interest rates four times in 2018, trade war tensions were ratcheting-up, global economic growth slowed and the yield curve inverted. Investors got nervous and sold stocks. In 2019, the Federal Reserve cut interest rates three times, trade tensions eased, global economic growth stabilized and the yield curve normalized. Investors regained confidence and bought stocks.
Corporate profits for the full year have not been reported yet but they will likely be up by only 1%. Valuation expansion therefore will have accounted for all of the price appreciation of stocks. The forward price/earnings multiple increased from 14x at the end of 2018 to 18x at the end of 2019.
This is a presidential election year which historically has produced positive market results. In the twenty-two elections since the S&P 500 was created the index has been up eighteen times with an average election year gains of 11.3%. Trade tensions will likely ease, geopolitical rhetoric will likely soften, the Fed will likely keep rates stable… continuing the benign environment for stocks.
Corporate profits are expected to grow by 6% this year. This seems like a very reasonable forecast given the current economic backdrop, it may even prove to be conservative.
It might be argued that the current forward price/earnings multiple of the S&P 500 is high at 18x given the average over the last 25 years is 15x, but it is not unreasonable in the context of low inflation and low interest rates. Perhaps more comforting is that the price/free cash flow ratio is only at its 25 year average.
What could go wrong? Geopolitical risks are my greatest near-term concern. I am writing this article the day after the Iranian retaliation of the Soleimani killing. Tensions have softened but are not gone and could reignite. North Korea could demonstrate advancements of its weapons programs causing a U.S. response. Either of these would rattle markets.
Another concern is the possibility that U.S. and China are unable to make progress on Phase Two of a comprehensive trade deal protecting U.S. intellectual property. This might result in a new round of tariffs and two sets of global technology standards in important areas such as 5G – both causing slower economic growth. This too would not be good for markets.
But this is an election year and our politicians want to get reelected. I expect a benign backdrop and a year of positive but more modest returns. Let me take this time to wish everyone a very Happy, Healthy and Prosperous New Year!