2019 Earnings Growth Could Surprise Skittish Investors

By LCK Wealth Management on February 1, 2019

In December 2018, the stock market acted as if 2019 U.S. corporate earnings were going to be devastated by a combination of Federal Reserve (Fed) policy mistakes, the end of tax-cut effects, a slowdown in global growth, and consequences of severe trade frictions. A shift in Fed rhetoric after Christmas sparked some recapture of earlier price declines, but investor concerns remain piqued and prices have yet to fully recover.

Earnings growth in 2019 will indeed slow from its unsustainable, tax-cut-driven pace of 2018 and may even fall below its 80-year average of 7 percent; however, even 6-to-7 percent earnings growth should support rising equity prices as 2019 unfolds with better economic policy impact and trade outcomes than investors currently seem to expect. Today’s more reasonable equity valuation levels and real U.S. GDP growth of about 2.5 percent in 2019, paired with continued share buybacks and some fiscal stimulus from China and elsewhere, should support high single-digit equity returns in the U.S. – a much better outcome than was available in 2018. The key message to investors: the U.S. economy is far from a recession, and earnings seem likely to grow at a better pace than equity prices currently suggest.
Fourth-Quarter Investor Concerns Pummel Markets

Investor concerns in the fourth quarter aligned to push equity prices down by as much as 20 percent from the October highs to the 2018 lows on December 24, 2018. Fears of a monetary policy mistake, slower global growth, increased trade frictions with China, and the end of year-over-year tax-cut effects generated increased concerns about a U.S. slowdown, if not a recession. Investor sentiment was reflected in strong flows to money market funds, “capping their best year since 2008,” according to Morningstar. Stock prices plummeted. The S&P 500 fell 13.8 percent in the fourth quarter – its worst performance for the period since 1931. The price drop created a “re-evaluation miracle,” according to Jim Paulson, Chief Investment Strategist of The Leuthold Group, as the price-to-earnings multiple (P/E) on the S&P 500 declined from its highest quartile to its lowest quartile. The chart below illustrates the effect of recent stock-price movement, as the trailing 12-month P/E ratio fell below its 10-year average in December and remains below its 5-year average today.

As the chart implies, during the last week of 2018, equity prices began to recover from what might have been characterized as oversold levels. The action was, in part, initiated by a recanting of previous Fed wording into more dovish language in late-December speeches by Chairman Powell and other Fed members. While the Fed’s response was temporarily helpful, investor concerns remained and, by the end of December, investors were able to add the unknown impact of a prolonged government shutdown to their “wall of worry.”

2019: Potentially Better Than Expectations

Investor fears must be taken into account, but – like the fear of a Fed-policy mistake producing a recession in 2019 – those that would most seriously affect equity valuations are unlikely to be realized. Economic growth in 2019 was never expected to match the unsustainable 2.9 percent level anticipated for 2018, but even with a record partial-government shutdown, a recession is not yet close to unfolding: employment continues to expand, wages continue to grow, consumers continue to spend, and lower fuel prices in 2019 should further support discretionary spending.

In addition, fiscal stimulus via the Tax Cuts and Jobs Act (TCJA) as well as the Bipartisan Budget Act (BBA) will be greater in calendar year 2019 than it was in 2018. The Peterson Institute for International Economics reports that the combined stimulus of TCJA and BBA will be $360 billion in 2019, as compared to $276 billion in 2018; although the incremental effect on growth from 2018 to 2019 will be less than it was from 2017 to 2018, it will still be positive – and a surprise to many who believe government stimulus ended with 2018.

Increased stimulus, growing employment, and rising wages will collectively contribute to GDP growth of about 2.5 percent in 2019 – somewhat less than the 2.9 percent expected for 2018, but better than both the 2.3 percent growth of 2017 and the average of 2.16 percent experienced from 2010 through 2017. Global growth is also set to slow slightly in 2019, but not dramatically. At the Davos World Economic Forum in late January, Christine Lagarde, Managing Director of the International Monetary Fund (IMF), projected 2019 global growth of 3.5 percent, down slightly from the 3.7 percent expected for 2018. With 43 percent of S&P 500 companies revenues coming from outside the United States, global growth of 3.5 percent will help to support higher revenues and earnings growth.

Real growth of 2.5 percent in the U.S. and 3.5 percent globally should allow for S&P 500 revenue growth of 5.5-to-6.0 percent – and earnings growth should be even better than revenue growth. With the efficiencies gained through developments such as artificial intelligence and robotics, along with the leveraging effect of continued share buybacks, earnings growth close to the historic average of 7 percent seems realistic. In addition, fiscal-policy stimulus plans announced by China, Germany, and Switzerland should underpin global economic assumptions, if not provide some pleasant earnings surprises.

From a valuation perspective, equities seem fairly priced, even after the appreciation seen so-far in 2019. While the earlier graph used 12-month trailing earnings for perspective, using forward earnings paints a similar picture of relative value. The forward 12-month P/E ratio for the S&P 500 is 15.4 according to a January 25 report from FactSet; as with trailing earnings, this is not as low as that produced by the market capitulation in December, but it remains below the five-year average of 16.4 and only slightly above the 10-year average of 14.6. While such a valuation is not so cheap as to justify a major overweight in U.S. equities, it may be reassuring to investors who remain concerned about the December price decline. Investors who reduced equity holdings to increase cash and those now considering a reduction in equity holdings may want to reevaluate their expectations for economic growth and earnings in light of the Fed’s intentions, continued fiscal stimulus in 2019, and economic growth that is likely to be better than the average annual rate since the last recession.

Portfolio Considerations

1. Economic growth of about 2.5 percent and earnings growth of close to 7 percent should allow equity to outperform fixed income in 2019. For investors who may have recently reduced equity holdings or want to rebalance portfolios to take advantage of more favorable equity prices than existed early in the fourth quarter. Although an index fund can also be used to gain equity exposure, the likelihood of shifts in trade, foreign stimulus, and Geopolitical events suggest that active management will have sufficient opportunity to outperform a static portfolio in 2019.
2. For investors seeking a more directed approach to value in the equity markets, a tilt towards Value stocks and away from Growth stocks may be timely. Based on IBES data by Refinitiv, forward P/E ratios for Value stocks relative to Growth stocks have been far lower in the past two months than in any other time in the past 15 years; in fact, Russell 2000 Growth stocks recently traded at a P/E of 32.1, compared to Russell Value stocks at 15.0. At times in 2009 both sectors traded at the same P/E – close to 20. Similarly, the P/E ratio for the S&P 500 Citicorp Value sector (12.5) currently trades at its lowest level relative to its Growth counterpart (19.0) in the last 15 years. Again, at various times in 2009 both sectors traded at the same P/E – around 13.
3. For investors interested in a more focused approach, the Healthcare sector may also be of interest. Even though it was the only S&P 500 sector that was positive in 2018 (+4 percent), areas such as biotech and digital healthcare could help contribute to relative outperformance in 2019; as it comprises 16 percent of the S&P 500, there is opportunity for diversification within this segment. Considered a defensive sector, Healthcare may also perform relatively well if the U.S. economy for some reason fails to live up to our expectations of 2.5-percent growth.

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