by Brad Houle, CFA
Executive Vice President
With stocks, only two things matter: earnings and what investors are willing to pay for a dollar of earnings. Reducing equity investing to these two variables should make forecasting the stock market relatively simple; however, the two variables are influenced by an almost infinite number of factors.
Following last year’s more-than 30 percent gain in the stock market, clients are naturally wondering what is next in 2020. It is not a heroic prediction to indicate that this year will probably not be as good as last year. In addition, we are closer to the end of the economic cycle than we are the beginning. It is, however, too early to get overly defensive and go underweight stocks. We continue to recommend a neutral weighting to stocks. For example, if a client has investment guidelines for large company stocks that are between 25 percent to 65 percent then the neutral weighting in large company stocks should be right in the middle at 45 percent. That being said, we have been reducing risk within client portfolios by starting to emphasize investments in economic sectors that are less cyclical.
Looking more closely at the valuation of the stock market it can be described as not being inexpensive. However, it is by no means at nosebleed price levels with a price-to-earnings multiple of 18x next year’s earnings. This means that investors are willing to pay 18x for each dollar of earnings of the stock market. The higher this number, the more expensive the market is perceived to be. The long-term average of the price-to-earnings multiple is 16x. Last year, almost 80 percent of the more than 30 percent increase in the stock market was attributable to multiple expansion, or, said another way, what investors were willing to pay for a dollar of earnings. One of the largest contributors to investors willing to pay more for earnings was a sharp drop in interest rates that made risk assets like stocks more attractive investments. We believe it is unlikely for investors to be willing to pay substantially more for a dollar of stock market earnings in 2020.
Earning growth is the second piece to the puzzle in determining what the stock market will do in 2020. In 2018, earning growth was more than 20 percent due in part to the changes in corporate taxes. For the full year of 2019 earnings were projected to grow about 1.9 percent due to continued, but slower, global economic growth. The Wall Street consensus for earnings growth in 2020 is currently 9 percent, which we view as overly optimistic. In reality, we believe full year 2020 earnings growth is more likely to be around 4 percent.
This backdrop of a full valuation in stocks and muted earnings growth leaves us in an environment for unexciting single-digit stock returns. However, with no recession on the horizon, it is still too early to get defensive and go underweight stocks.
Today, the December jobs report came in at a little below expectations, yet the six-month average number of jobs created continues to be robust. Unemployment remains at 3.5 percent, the lowest in 50 years. For 2020, the stock market is up 1.5 percent, near an all-time high.
Week in Review and Our Takeaways:
With stocks, two things matter, earnings and what investors are willing to pay for a dollar of earnings
The stock market is not inexpensive on a valuation basis and projected earnings growth does not look robust. However, we don’t see a change in the economic cycle that would warrant being underweight stocks