2020 Market Outlook

December 31, 2019

Solid, Though More Modest,
Gains Likely For Stocks In 2020


John Boyd

Last year when I sat down to write my Outlook for 2019, things looked bleak. The Fed had just hiked rates for the fourth time in 2018. Many pundits expected a recession as a result of the trade war with China and prospects for a disastrous Brexit. The stock market was plunging with the Nasdaq and small-cap Russell 2000 in bear markets (down 20%+) and the S&P 500 narrowly avoiding that fate falling 19.7%. Fear was rampant with the CNN Money Fear and Greed index registering extreme fear. And half of those polled by the American Association of Individual Investors (AAII) were bearish (versus a long term average of 30%) — the highest reading in five years. In 2018, despite corporate earnings growing 22%, the S&P 500 recorded its first annual decline (-4.4%) in 11 years, driving the year-end price/earnings ratio (P/E) to 16.5 — the lowest since September of 2013.

Today, things are totally different. The Fed cut rates three times in 2019 and talk of a recession has waned. Trade issues have thawed a bit with China. And with the election victory by Boris Johnson, a relatively benign Brexit now seems more likely. Despite earnings growing just 1.7% over the past 12 months (through September — the last quarter for which we have data), the S&P 500 gained over 30% in 2019, pushing the P/E at the end of September up to 19.4 — essentially right at the 25-year average. The CNN Fear and Greed index is now registering extreme greed, and bearishness in the AAII poll is down to 20%. While things may seem like they are a lot better now, not all these changes are positive for stocks. Let’s look at the good and the bad.

S&P 500 Operating Earnings P/E Ratio

The Good News

I talked about this last month, but it bears repeating: The most significant positive change for stocks is undoubtedly the shift in Fed policy from tightening to easing. “Don’t fight the Fed” is still a good rule for investors. Even more important than their 2019 rate cuts was their telegraphing that they will hold off on returning to a tightening mode even if inflation rises above their target (2.0%), but be quick to cut rates further should the economy show signs of deterioration (the Powell Put?). So investors have little to fear from a Fed that will not raise rates unless the economy accelerates much faster than expected, driving inflation well above 2.0%, in which case stocks will likely be doing fine thanks to the growth in the economy.

The market hates uncertainty, sometimes even more than clearly bad news. For almost all of this year uncertainty over the trade war with China and the prospect of a "messy" Brexit hung over the markets serving as a roadblock to companies making investment plans. There is more clarity about both now, which is good for stocks.

If history is a guide, the market’s strong performance in 2019, suggests solid, if less spectacular, returns in 2020. Since 1950, when the S&P 500 is up 20% or more for the year, the following year has been positive 83% of the time with an average gain of 11.2%. And if the Nasdaq is up 30% or more, the next year is positive 78% of the time with an average gain of 14.2%.

It may seem bad that corporate earnings growth slowed to a crawl this year, and it was — for 2019. But it does make it easier to show solid earnings growth in 2020 when compared to last year’s weak results. (2018’s 22% growth was a challenge for 2019’s growth.)

The Bad News

The sudden bullish shift in investor sentiment is not the most welcome news, as such sentiment is typically viewed as a contrary indicator suggesting that a correction may be around the corner. That would actually not be a bad thing as periodic corrections are part of a healthy bull market and we haven’t had one since the fall of 2018. It’s also important to note that in terms of actions rather than sentiment, investors continue to dislike stocks. According to the Investment Company Institute, over the past two years investors have shed nearly $250 billion in equities (stock mutual funds and ETFs) while buying about $530 billion in bonds. In fact, investors shed stocks in 11 out of the 12 months of 2019. Should this start to reverse it could provide a powerful tailwind for stocks.

Cumulative Cash Flow since 12/31/17 in Billions

The jump in valuations is probably the most negative change for stocks. Based on full year earnings estimates and the current price, fully 85% of the increase in the level of the S&P 500 (i.e. excluding dividends) will have come from P/E expansion and just 15% from earnings growth. That is likely not sustainable. However, as noted earlier, the P/E of the S&P 500 is currently almost exactly at the average reading over the past 25 years, so there is still some room for P/E expansion, but not likely to the degree that we saw in 2019. So the key to good stock returns for 2020 will most likely be solid earnings growth.

Earnings Rebound Expected

Forecasted earnings for 2020 currently call for just that. S&P 500 earnings per share are currently estimated at $176, which would translate into a gain of about 11% over 2019’s full-year estimate of $158. One caveat is that estimates for 2020 are still being cut by analysts, but the rate of decline has slowed recently.

S&P 500 Earnings Growth Year/Year Quarterly % Change

If the P/E remains at 19.46 (as of third quarter of 2019 the last available data), and earnings come in as forecast at $176, that would translate into an index level of 3425 for the S&P 500, or a gain of about 6% from here. Add in around 2% for dividends and you get an 8% total return. If the P/E moves just a bit higher to say 20.46 that would yield a total return of about 13.5%.

However, the above ignores the impact of stock buybacks, which have run at a heavy pace. In the third-quarter of 2019, nearly 70% of the S&P 500 companies reduced their shares outstanding through buybacks — 23% reduced shares by 4% or more. A 4% reduction in shares means a 4% boost to earnings per share. Should buybacks continue apace, that would boost the above S&P 500 returns further.

No Recession Likely

GDP growth is forecast to finish 2019 at 2.3%. Most analysts expect further moderation to around 1.9% in 2020. As noted earlier, recession fears have waned, due largely to the Fed’s shift to monetary easing, but also the improving picture for trade and Brexit. In fact, there are several economic indicators that have been extremely negative this year, but showed tentative signs of bottoming in November, including industrial production, factory orders and non-defense capital goods. And my favorite composite indicator, the Chicago Fed National Activity Index (which uses 85 different economic indicators) is showing signs of bottoming as well (see below).

Chicago Fed National Activity Index -- 3 Mo. Moving Avg

Foreign Stocks

Over the past decade, foreign stock performance has significantly lagged the U.S. As shown below, the S&P 500 has generated a cumulative return of 256% versus just 59% for the MSCI EAFE index. That may soon change.

Cumulative Returns Last Decade

Europe, in particular, has been unloved for a long time. And valuations there are more attractive than here at home. Much less uncertainty around Brexit, asset allocation decisions away from negative-yielding bonds, and investors who are significantly underweighted in the area, may all boost demand for European stocks. In fact, after 85 weeks of consecutive outflows totaling $150 billion, only now is the region starting to see inflows. If the eurozone economy starts to recover, European stocks could outperform. On that score is the interesting observation that an inverted yield curve in the U.S. (as we saw earlier this year) has often marked the beginning of a change in long-standing trends such as foreign stocks lagging the U.S.

 — John M. Boyd