Thoughts on 2019 – Investor Pessimism and the Potential for PE Expansion

Take any forecast or expected return discussion for 2019 with a substantial grain of salt.

In 2017, this blog’s forecast for the SP 500 was pretty solid, looking for a 20% year where, in fact, the SP 500 returned 21.5% – 22% last year, possibly in anticipation of tax-reform.

In 2018, the SP 500 forecast was less accurate, since an “average” year was predicted for the SP 500 (and I thought given the SP 500’s return as of September 30, 18, the forecast would be too low) of between 7% – 12%. Instead the SP 500 forecast was far too high, in a year where SP 500 earnings will grow 23% – 25% versus 2017.

Think about that: The SP 500 will likely have a low-to-mid-single-digit NEGATIVE return in a yer where SP 500 earnings grew well over 20% for the calendar year. (Kinda shoots a hole in the boat for the purpose of this blog, which is talking SP 500 earnings forecasts.)

What makes it even worse, as last night’s blog posits, the SP 500 “organic” earnings growth rate (ex tax-reform influence) was still +14%, (per IBES for Refinitiv), so – again – we had mid-teens organic SP 500 earnings growth in 2018 and still a negative SP 500 return for the year.

Fundamentally and from a macro perspective this is what I’d like to see happen in 2019:

  • The Fed turn dovish (meaning a slowing or stopping of tightening monetary policy) given the absence of any real inflation. 10 years into an economic recovery and with a 3.7% unemployment and stretched labor markets and there is STILL no real threat of wage or price inflation. It is “unanticipated” inflation that spooks the Treasury market anyway, but you would think if US investors were to see wage inflation, it would have happened by now. Im a big believer that it’s wage rather than commodity inflation that will do in the Treasury market and see interest rates spike markedly.
  • US – China trade talks get put behind us. While most investors blame the Fed for the negative SP 500 return this year, think of the uncertainty trade talks have to have created since 35% of the SP 500 revenue is non-US and CEO’s don’t yet have the new playbook. Jeff Miller, the excellent blogger at “Dash of Insight” wrote in early December ’18 that the trade talks would be more “process” than big headlines (like Mexico and Canada were) so the rice deal by China announced Friday, December, December 28th and the two month hiatus on auto tariffs announced a few weeks ago are small, tangible steps much like Jeff Miller suggested would happen.
  • Brexit: the world’s 5th largest economy needs to get this resolved. I do think the slow growth in Europe is a function of the Brexit realignment and like Fed policy and China trade it slows down decision-making at the corporate board and CEO level. It has to be difficult to know how to do 3 – 5 year planning for capex and investment when you don’t know the playbook and the rules for even the next 12 months.

The key element to these three “macro” events is that we should have some substantial resolution to all of these by March 1st. The first quarter of 2019 will be critical: Brexit is headed for a March 1 deadline and China trade talks will likely see some firm conclusion by then too, as the US auto tariff hiatus announced a few weeks ago, expires March 1, ’19. Might we hear something different out of Powell and the Fed ? We will know more on January 31, the date of the next FOMC meeting.

  • SP 500 forecast for 2019: high-single-digit-to-low-double-digit return for 2019, based on 7% – 10% SP 500 earnings growth next year. Expect a year of “PE expansion” too. The retail investor pessimism around 2019 is palpable. Expectations are so very low for equity returns. That’s a good thing for long-term investors. Investors haven’t seen two consecutive years of negative returns for the SP 500 since the Nasdaq fell 80% from early 2000 through the lows in 2002. Before that it was 1973 – 1974 where the SP 500 declined 2 years in a row.
  • Bloomberg Aggregate (AGG) forecast for 2019: After 2 negative years of primarily negative Aggregate returns for the Bloomberg Barclays AGG, expect a positive year, but still single digits. In terms of my own confidence around probabilistic returns, I think the bond market could offer paltry returns for years. Then again there is just no inflation. That’s the key to this entire asset class.
  • US dollar – flat to weaker after the strong year in 2018, unless Jay Powell and the Fed ignore everybody and want to hear Corporate America squeal. I would think the Treasury would leaning towards “dollar weakness” since it helps take some pressure off US exports to China. Let the dollar weaken a little.

Portfolio changes expected in 2019: 

1.) Clients have seen their emerging markets and Non-US weights increase gradually this year from 3% – 5% to up to 10% as of today. The EEM and the VWO as of this writing have 5-year “average annual” returns of just 1%, while the SPY’s 5-year return is 8.25% per Morningstar data. The three client holdings for Emerging Market exposure are EEM, VWO and then the OakMark International Fund managed by David Herro. Herro has an excellent long-term track record (although the 12-month numbers look pretty horrid, which is why I’m buying into it for clients) and will buy into developed markets as well. Anything non-US today has gotten crushed. We were early and wrong on lifting clients emerging markets weight in 2018 – see these articles here, here and here – but the weight currently is heading towards 10% and the maximum weight will be 15%.

Sector overweights in Financial’s will remain the same. Clients will be closer to a neutral weight in Technology and Consumer Discretionary and Communications and Health Care.

With these 5 sectors of the SP 500, investors get about 2/3rd’s of the SP 500’s entire market cap.

2.) With a less restrictive monetary policy in 2019, some high-yield (HYG) has started to be bought for clients as well as a high yield bond mutual fund. High yield credit spreads have widened out to 7% – 8% as of year-end 2018, versus the summer lows near 5% which isn’t great but after the Fed round of rate hikes perhaps we see a more stable bond market in ’19. Clients have been in a Schwab higher yielding money market for over 2 years, just walking up the short-end of the yield curve, so some cash will be reallocated into some credit spread product. Clients have seen good “alpha” from fixed income allocations but the returns are so diminished relative to equities, the performance discussion never gets much recognition from the client. The flatter yield curve worries me – just not the way you hear in the mainstream media.

3.) One of the favorite parts of the market for me personally is the “Original Gangster” stocks from the 1990’s which now includes Pfizer and even Merck from the large-cap pharma era, that are re-positioning their business models to set themselves up for growth in the next 10 – 20 years. Microsoft will likely remain clients largest holding, as will Schwab, and then I try to look for long under-performing and beaten down names that could get a catalyst. Cisco is looking good and with the late-2018 pullback in the SP 500, its being bought for clients. Within Tech there is always the “new growth companies” versus the “old growth companies” and as the current bull market ages, clients see more “old growth” with the potential for new ideas being owned. These companies don’t exactly fit the “value” category, but maybe just “cheaper growth” is the way to label them.

What are the biggest worries headed into ’19 ? 

  • Unexpected and unanticipated inflation which will force Jay Powell’s hand to not back off on fed funds rate increases, and “quantitative tightening”.
  • The trade talks with China which force the President and the trade team to play hardball.
  • A much stronger dollar which could result from the first worry.

Summary / conclusion: Think of one year ago, and how bullish investors were with tax cuts and expectations for a great 2018. Reality was a harsh surprise. I do think expectations are too low for 2019 and we will see  a return to a more normal year of “PE expansion”. SP 500 earnings should grow at 8% – 10% in 2019, again a more normal year.

One final word of advice to readers: take all this with a healthy dose of skepticism and pessimism, especially the forecasts. The reason for writing the blog is to force me to lay out the logic for portfolio actions and decisions. Readers can agree with them or not.

Thank you for reading – have a wonderful New Year.



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