FOMO Real But Other Fundamental Stock Drivers Also At Work

Conventional wisdom is something that investors generally should be wary of. Right now, the headlines repeat that “fear of missing out,” or FOMO, is driving the U.S. stock market to new highs. True enough but conventionally true. I don’t deny it and we said months ago in these very pages that FOMO might happen—and it is driving equity prices. However, it is not new and is already conventional wisdom.

I believe this rally is more about a potential falling equity risk premium, which should lead to a higher price/earnings (P/E) ratio. The new year is young, but since its start, one could argue that the incoming economic data points have been negative, with for example, a weak December manufacturing index from the Institute for Supply Management (ISM), coming at 47.2 vs and expected 49, and the lowest point since 2009’s 46.3. (More on this below.) Add to that some fierce, if temporary, geopolitical tension and yet the S&P 500 index has risen five of the first six days of 2020.

It shouldn’t surprise that, given the negative data skew, some attribute the rise in equities to FOMO.

But our conversations with discretionary, macro and global fund managers suggest a bigger different driver is at work: investors are becoming comfortable with the notion that equities valuations can re-rate higher in the salutary macro environment in which we find ourselves: benign inflation; an accommodative Federal Reserve; stable to improving growth outlook, along with significant cash on the sidelines.

This suggests to me the equity risk premium could be declining. In other words, just plain fear of equity risk is easing. This would look like an environment similar to that of 1998, 2003 and 2010, and it would be consistent with the bullish Fund Manager Surveys by Bank of America that we have noted in past issues.

• If this is the case, then the upside for U.S. stocks in 2020 is considerably higher than our 3,450 YE target on the SPX, as our base case is predicated solely on earnings per share (EPS) growth of +10% sans P/E expansion. However, if stocks are indeed in the process of re-rating higher, which I believe is likely, then each point of P/E expansion is worth 5% upside. Currently the SPX trades at a bit over 18 times 2020 estimated EPS of $178.

• Furthermore, from a strategy perspective, this suggests to me a much broader market in 2020 compared to 2019, when only 3 stock sectors outperformed (technology, financials and communication services), and where growth and value investing styles produced nearly identical returns at around plus 29%. Our base case is that 2020 would look like 2010 (or even 2016) and thus be broader, so I continue to see EPS recovery stories outperform the most – namely, technology, industrials, energy, materials and financials.

• It appears the “shallow” EPS recession of 2019 might be ending by 2Q20, as revenuediffusion, or percentage of GICS level 1 sectors with positive year on year salesgrowth, appears to have bottomed in 2Q19 at 72%. Reported 3Q19 results show thisrose to 82%, or nine of 11 sectors, with only industrials and energy showingnegative YoY top-line drops. Without those sectors, YoY revenue growth shouldhave been similar to 2Q19 (4.7% vs 3.9%).

• So already, this is a shallower than2015, where by 3Q15, only 63% ofsectors had top-line growth (ISM wasbelow 50 for 6 months already).Today’s scenario looks more like theEPS recessions of ‘93, ‘95 and ’98,which were two-three quarterdeclines. Similarly, the current EPSrecession could be viewed as mild sincethe top line growth remains positiveand therefore is not necessarilypointing to a deepening and sustainedweakness.

• The latest ISM PMI survey showed increased weakness for US manufacturing inDecember, which is incongruous with other manufacturing surveys. The US MarkitPMIs remain well above 50 and the global Markit PMIs are now stronger than the US. To an extent, I believe Boeing’s December 16 MAX 737 production suspensionannouncement affected the Dec. US ISM surveys, coming as it did mid-month, whenthe ISM survey would have still been open. But, as noted, top line growth for S&P500 is already recovering. One way to reconcile the ISM vs Markit PMI divergences,is to look at the reported results by S&P 500 companies.

And the spread from my favorite yield curve, the U.S. Treasury 10-year – 30-year continues to steepen. I view this curve as less manipulated by monetary policy and therefore more purely macro sensitive. This curve reached its narrowest in mid-2018, which I believe forecast the subsequent slowdown in the PMIs (see our past reports.) Thus, the steepening throughout 2019, in our view, signals stronger growth in 2020.

What could go wrong? Business confidence surveys are diverging: US ISM PMI <50 but rising for Markit US PMI, and globally too. What if the US ISM is correct and those others are set to collapse? We will see in the next few months.

Bottom Line: We expect a broader and more cyclical market in 2020. We have identified 25 stocks which are in the 6 cyclical sectors with accelerating EPS and also ranked Quintile 1 in the Doctor Quant Model. The tickers are RL, BBY, TGT, LEN, HAS, ARNC, CAT, CMI, NSC, GWW, PYPL, QCOM, TXN, MSFT, AAPL, CF, EMN, COP, EOG, CFG, FITB, MTB, SYF, DISCK and TTWO.

Figure: Comparative matrix of risk/reward drivers in 2020
Per FS Insight

Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/9/2019