Stock market valuations may have gotten ahead of corporate earnings and economic fundamentals. The much-anticipated rebound in global growth needs to show up soon.
As 2020 gets underway, the U.S. stock market is showing remarkable strength. The S&P 500 is up 35% since the lows of December, 2018, the last time the broader market index marked a 20% decline, which was a technical, but short-lived, bear market.
As of mid-January, markets stayed resilient—even in the face of the recently heightened Mideast tensions—as investors remain confident in the improved outlook for global growth, amid less uncertainty around U.S.-China trade issues and an endgame for Brexit.
The only catch: That rosy global rebound scenario will eventually have to materialize—and the clock is ticking. Below are three areas where investors can measure progress:
- Corporate and economic fundamentals are lagging: Recent U.S. economic data has been mixed at best. Manufacturing remains near recessionary levels, even as the U.S. consumer is strong. Corporate earnings have been unimpressive, especially if you factor out the benefit of share repurchases, which can generate an earnings-per-share improvement simply by reducing the number of shares outstanding. Morgan Stanley & Co.’s Chief Investment Strategist Mike Wilson forecasts that, at most, the S&P 500 will show 3% earnings growth in 2020.
- Monetary stimulus may not last: A short-term infusion of Federal Reserve liquidity since September has helped fuel U.S. market gains. The central bank has expanded its balance sheet by $460 billion in less than four months, a very rapid and large injection, returning it to over the $4 trillion level it reached during the later stages of the Fed’s bond buying program, which followed the financial crisis. While Morgan Stanley & Co. analysts estimate that Fed balance sheet growth will end by April, some analysts believe it could end as early as mid-January.
- Stock prices look rich: “Trees don’t grow to the sky,” goes a famous Wall Street maxim, meaning that stocks can soar in the short-run on sentiment, but ultimately, valuations are tied to earnings growth. Currently, price-to-earnings ratios on the S&P 500 are well above their 10-year averages on nearly every metric: earnings, cash flow, book value and sales. At nearly 22 times trailing earnings, the S&P 500 is in the top decile of valuation for the past 90 years.
History hasn’t been kind to markets driven to high valuations by excess liquidity. Some comparisons to the “tech bubble” of 1999–2000 are starting to look compelling to me. For example, now, just as then, market gains are concentrated in a handful of tech giants. It’s also worth recalling that short-term Fed liquidity added to hedge against fears of Y2K disruptions also helped fuel the final blow-off of the tech bubble.
My advice is for investors to rebalance their portfolios—as often as every quarter this year—in case market excesses continue to develop. That could mean scaling back on outperformers that seem overpriced and adding more high-quality value stocks that may have been left behind. Also, keep an eye on fourth-quarter 2019 corporate earnings reports to see if the anticipated rebound in growth materializes before the Fed starts to pull back on liquidity. That’s when the clock could stop ticking.