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Stocks in 2020: Through the Bullseye

Will the stock market continue its bull run in 2020? Learn which indicators to watch from Morgan Stanley Investment Management's Andrew Slimmon.

Nobody would argue that the stock market isn’t a complex beast, yet for all its volatility, the market often exhibits remarkable consistency relative to its historical behavior.

Sadly, in 2012 and 2016, investors reacted to the drawdowns of the previous years by selling equities into a rising market. Since 1984, there have been only nine years of net outflows from stocks, and these were two of them. Count 2019 as another.

Over that same time period, the year after a net-outflow year—call it “the second year after a pause year”—has always been positive for the Standard & Poor’s 500 Index, as investors capitulated and went back into the market. In 2013 and 2017, investors poured money back, and they were great years for returns. We think 2020 will see a similar dynamic.

The biggest risk for equities this year is if the economy becomes too hot. In that scenario, we worry the Federal Reserve might have to adjust policy in 2021, which could handicap returns down the road, but we doubt it would impact stocks in 2020.

After 2019’s lackluster year-over-year earnings, the bar will be low and thus easy to achieve good numbers. The combination of a President who wants a hot economy going into an election, the Fed pumping liquidity, reduced China trade uncertainty, the United States-Mexico-Canada Agreement and the wealth effect of a good stock market suggests that the surprise could be to the upside.

Here are some of the key trends we're watching this year:

Fund Outflows Indicate Positive Returns

One reason this bull market has endured is due to several mini-corrections—after which fund investors have retreated—followed by periods of capitulation. In fact, positive stock returns have consistently followed some years with negative equity fund flows; the pattern has been particularly pronounced this cycle.

Equity ETF &
Mutual Fund

S&P 500
2011 -$60.9 B +2.1%
2012 -$28.7 B +16.0%
2013 +356.2 B +32.4%
2015 -$97.2 B +1.4%
2016 -$70.3 B +12.0%
2017 +186.5 B +21.8%
2018 -$47.3 B -4.4%
2019 YTD -$201.5 B +31.0%

Source: ICI, Bloomberg as of 12/20/19. See Risk Considerations and Disclosures below.

For example, mutual funds and exchange-traded funds experienced two years of outflows in 2011 and 2012—investors pulled about $90 billion out of equities, even while the market was rising. Then, in 2013, they poured $356 billion back into equity funds, and the market ended the year up more than 32%. The same happened again in 2015 and 2016, when investors pulled $97 billion and then $70 billion, respectively, while stocks rose, only to return in 2017.1

We're poised for a third such capitulation this year. Fund outflows in 2018 and 2019 totaled about $250 billion.2 Barring a major disruption in markets or change in human behavior, investors are likely to put money back to work in 2020.

The upshot: Following a pattern of equity fund flows where investors cash out two years in a row while the market rises, only to return the next year, investors in stock funds are likely to reinvest in 2020 after pulling money in 2018 and 2019.

2020 Stocks: The Best Environment

In the last decade, predictions of doom and gloom proliferated but never materialized. The short explanation is that markets don't bust without a boom.

In 2019, the U.S. economy continued to simmer on relatively low flame, adding to what has been the longest expansion on record, though still well below long-term historic GDP growth. That sets a relatively low bar for growth in 2020, which will likely accelerate after riding the tailwinds of last year's accommodative monetary policy.

Investor Stanley Druckenmiller said it well: “The best environment for stocks is a very dull, slow economy that the Federal Reserve is trying to get going."3

The upshot: Without a boom, there can be no bust. With below-par economic growth, there hasn’t been a boom, which is why calls for a recession have failed and the economy—and stocks—can now benefit from lower interest rates.

Inverted Yield Curve: Timing Is Everything

An inverted yield curve, in which long-term debt yields less than short-term debt of the same credit quality, often, but not always, signals a coming recession. That's why, when the 2-year and 10-year yield curve inverted in August 2019, many investors worried about an economic slowdown and stock market pullback.

But timing is everything. The last four times the yield curve inverted, the market rallied for another two years, surging 40% on average. Assuming such a two-year lag from the August inversion before a downturn, the stock market could rise steadily into early next year.

Inverted Yield Curves Tend to Precede Market Peaks by About Two Years

Initial Inversion

Stock Market Peak

Time Difference
S&P 500 Gain From
Inversion To Peak
8/17/1978 11/28/1980 834 days 51.57%
12/14/1988 7/16/1990 579 days 41.46%
4/24/1998 9/1/2000 861 days 41.60%
12/27/2005 10/9/2007 651 days 28.80%
AVERAGE:   731 days 40.86%
8/22/2019 ? 124 days so far 11.01%

Source: Bloomberg as of 12/24/19. See Risk Considerations and Disclosures below.

The upshot: When considering the implications of an inverted yield curve, consider the historical lag between a yield curve inversion and stocks falling—one indicator that supports the view that stocks have more room to run.

Asia Ex-Japan and U.S. Equities

The only region we suspect will do better than the U.S. is Asia ex-Japan, where we like the growth names because they’re valued at what we consider to be substantial discounts to their U.S. counterparts.

In the U.S., value stocks became cheap last year, and though they’re correcting back to normalized valuations, they didn’t get to full-blown recessionary cheapness, which ultimately is the really fat pitch. We think they’ll continue to do well into 2020, though that could wane sometime later in the year.

Many of the uber-growth names were decimated in the second half of last year. Therefore, we do not believe we should necessarily sell growth for value at this time.

The upshot: Growth stocks in Asia ex-Japan are undervalued compared to those in the U.S., while U.S. value stocks can continue to do well in early 2020.

Adapted from the recent webcast “2020 Outlook: It's Not Really Complicated." For more information, ask your Morgan Stanley representative or visit Morgan Stanley Investment Management. Plus, more Ideas from Morgan Stanley’s thought leaders.