The stock market in 2019 put an exclamation point on a strong decade. U.S. stocks enjoyed one of their best years since the 2008 global financial crisis, supported by easing trade tensions, improving economic data and Fed rate cuts—though big-picture worries remain. The S&P 500 climbed through the decade despite six corrections greater than 10%. Coming out of the Financial Crisis, the Fed and European Central Bank launched stimulus programs to help calm the markets and provide liquidity. European policy makers had to handle sovereign debt levels in Greece, Spain, and Portugal. Energy prices fell over 50% in the middle of the decade causing hundreds of bankruptcies. At the end of 2018, recession fears hit markets around the world as trade war worries hit a fever pitch and the Fed announced plans to increase rates three times in 2019. Yet, on a risk-adjusted basis, this was the best decade since the 1950s as the S&P 500 climbed a wall of worry and never had a pullback exceeding 20% throughout the past 10 years.
Strong earnings growth coming out of the recession in 2009 drove most of the decade’s returns. However, changes in valuation have driven the stock market returns over the past 2 years. While earnings were particularly strong in 2018 due largely to the late 2017 corporate tax cut, the stock market was essentially flat as the Fed increased interest rates three times and indicated they would continue to do so in 2019. However, the Fed actually lowered the Fed Funds rate three times in 2019 thereby pushing up stock valuations and producing strong returns despite flat earnings growth. Lower rates support higher stock valuations by making future earnings worth more when discounted back to the present at a lower rate. Dividend-paying companies also see greater demand from yield-seeking investors, and lower borrowing costs make share buybacks more affordable for companies
Over the full two-year period, the S&P 500 has risen nearly 21% while profits rose 25%. The forward price/earnings ratio on the S&P 500 is now slightly over 18, essentially where it stood two years ago. From that level, a further rise in U.S. stock prices will probably depend on higher corporate earnings, although the central banks in the U.S., Europe and Japan have all been engaged in a new round of quantitative easing (the quaint term for printing money electronically). The total assets of the Fed, ECB, and BOJ rose $264 billion year-over-year during November to $14.5 trillion.
The economic expansion is now in its 11th year, and the consumer will remain the driving force of the U.S. economy in 2020. Unemployment is at a 50-year low and wage gains are at a 10-year high. That means consumers have seen their spending power increase—good news for the economy, since consumer spending accounts for about 70% of it. And households have remained optimistic, with measures of consumer confidence remaining near their highs of the cycle. Strong consumer spending combined with low interest rates, higher fiscal spending, and the lack of excess inventories suggest economic growth could accelerate a bit in 2020 leading to stronger earnings. The current consensus for 2020 operating earnings growth for the S&P 500 companies is approximately 10%, although that number will likely trend lower over the course of the year. Continued free cash flow means corporations will continue to buy back shares and raise dividends. Some 334 of the S&P 500 companies shrank their shares outstanding in the past year, with 115 of them cutting their share count by at least 4%.
Fundamentally, perhaps the big risk for 2020 is a higher-than-expected rate of inflation and, as a consequence, interest rates high enough to cause a decline in price/earnings ratios that could offset the benefits of earnings growth. Rich Bernstein, the namesake of Richard Bernstein Advisors, expresses concern that, with both monetary and fiscal policies strongly pro-inflation, they may actually succeed! Moreover, trade tensions could continue to flare up, renewing the pressure on global manufacturing that was the major drag on international trade and economies in 2019. Two additional wild cards for 2020 are what happens with U.S.-China trade and the U.S. presidential election. Each has the potential to have a major influence on markets next year, and each is hard to predict.
Bonds also generated positive returns above their coupon levels in 2019 as yields declined. From the current interest rate level, a rise in the 10-year Treasury note yield to about 2.25%—or nearly a full percentage point lower than its peak of September 2018—would produce a price decline that would wipe out a year’s interest income. Our fixed income investments are high quality and shorter duration to minimize both credit and interest rate risk.
We anticipate that stocks will again outperform bonds and cash. We continue to focus on quality companies with solid balance sheets and cash flows.
Craig A. Vander Molen, CFA, CPWA ®
Managing Director and Chief Market Strategist