Investors shouldn't expect easy returns in 2019, but there are reasons to be optimistic, including economic growth, attractive valuations and inevitable swings in sentiment.
Going into 2018, investors saw U.S. equities markets as a glass half full, thanks to the promise of global synchronous growth and the extended absence of volatility. But, as the saying goes, a shift in perspective can rapidly make the same glass appear half empty. By autumn, market sentiment had turned, leading to a significant peak-to-trough decline of 19.8% for the S&P 500.
The glass may not be as full as it was earlier in this cycle, but we believe it’s not empty.
Looking ahead, there are reasons to be circumspect: Strong earnings growth in the first three quarters of 2018 make for tough comparables in 2019. Trade conflicts with China still linger, though my colleagues and I at Morgan Stanley Investment Management believe recent market weaknesses may force a compromise. Finally, although the Federal Reserve is expected to tread carefully, a pause on rate hikes could favor stocks—but a rate cut could also be viewed as bearish.
Nevertheless, investors would be wise to take a step back before drawing too many pessimistic conclusions about 2019. The glass may not be as full as it was earlier in this cycle, but we believe it’s not empty.
To be sure, above-average earnings growth for U.S. stocks in 2018 has set a high bar for 2019. While these challenging comparables create some vulnerabilities in the first three quarters, the key question is whether the market has already priced in expectations for lower earnings.
It would be naïve to think that markets have fully baked in all negative earnings; as we saw in early January, unexpected earnings revisions can still surprise. That said, the risks may be more idiosyncratic than widespread. Last year's declines may have wiped out most of the excesses hanging over U.S. stocks. Notably, earnings improved while the price-to-earnings ratio declined. At the end of 2018, the market traded at 14.3 times 2019 earnings.1
Although earnings recessions can be devastating to markets, most bear markets go hand-in-hand with economic recessions. The U.S. economy enjoyed hearty growth in 2018, but it fell short of the historical average, suggesting that year-over-year improvements aren't out of the question—and an estimated $70 billion in federal income tax refunds in 20192 could bolster consumer spending, still the biggest pillar of economic growth.
Bear markets (20% corrections or more) tend to be caused by recessions
It’s also worth mentioning that bull markets don't always follow a linear path. After a rally from March 2009 to April 2011, the Standard & Poor's 500 Index gave back 19.3% peak-to-trough. It then recovered and climbed 65% between 2012 and 2014, and paused again until early 2016, when it rallied another 69%.
With a Peak to Trough Decline of -19.8%, was 2018
a "Pause" year or Something Worse than 2011 and 2015?
(S&P 500, March 2009 to December 2018)
Mean reversion is a powerful force in markets, and it is fueled largely by shifts in perspective. Interestingly, there is typically an inverse relationship between investor sentiment and subsequent market performance.
The AAII Sentiment Survey—which measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market short term—shows that investor sentiment was high prior to pause years in an extended bull market and low near the end of those periods. That is to say, the lack of bullish sentiment today may be a positive indicator for the months ahead.
The Citibank Economic Surprise Index (CESI) shows a similar pattern. In mid-2017, expectations were low prior to a period of strong performance. That sentiment shifted into the extreme positive going into 2018—setting up investors for disappointment later in the year and likely exacerbating bad news.
Expectations Were Very High at the Beginning of 2018, Less So Today
(Citi U.S. Economic Surprise Index, Dec. 30, 2016-Dec. 27, 2018)
Meanwhile, volatility in 2018 wasn't entirely out of the norm. It only seemed shocking following the uncanny calm in 2017, when the S&P 500 logged just four days of more than 1% decline. That was the real anomaly. In fact, 2018 resembled 2015 in volatility, and was actually less tumultuous than 2011, when the market suffered through 48 days of significant price drops.
Value stocks are, by definition, always cheap, but sometimes they get excessively cheap, as is the case today. The last time valuations of value stocks were this low was in February 2016, on the eve of a 69% market revival.
Of course, there are times to buy value and times to avoid it. As long as there isn't an economic recession, significant divergences in value stocks are typically a buy signal. What's more, factors that have performed the best in the final legs of a down market—such as we saw in late 2018—tend to do best when the market recovers.
Momentum, meanwhile, has changed dramatically from the first half of 2018, when it was weighted heavily toward technology. Since fall, there has been a rotation out of technology toward defensive stocks, so much so, that the momentum bucket is crowded and expensive, but with defensive stocks. Technology stocks now appear to be a relative bargain.
As we pointed out late last year, extreme divergences in regional markets tend to result in dramatic reversals. Relative performance in late 2018 suggests that this shift has already begun.
China has Started to Outperform
Relative Performance of Shanghai Shenzhen 300 Index (CSI 300) vs. S&P 500
(December 31, 2017 through Present)
Consequently, we are slightly underweight North America, where we have a 54.4% allocation versus 65% for the benchmark. We are overweight Asia ex-Japan versus the benchmark. Finally, we have a small overweight to Europe. Although Brexit continues to hang over the region, Europe is so cheap in our opinion and investors’ expectations so low, that it could surprise to the upside on any positive news.
1 Bloomberg, 12/31/2018
2 Source: Ed Hyman
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