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Through 2020 and into 2021, it’s all about earnings per share growth for the Standard & Poor’s 500 index and potential U.S. equity returns. As noted last week, I see 10% plus EPS growth and that should translate into another double-digit equity return next year as investors begin to discount EPS of 2021 some12 months from now. Of course, it’s a Wall Street axiom that every year profits matter and 2020 is no different. Over the long term it’s true. However, in the short term sometimes EPS can matter less than price/earnings ratios (P/E)—and vice versa—for example. Let’s look at the big picture over the past few years. Remember, that the SPX EPS shot up over 20% in 2018 to $162 from $131, thanks mainly to a one-time Federal tax cut. Yet the result was a market that was down 6% in price. In 2019, earnings are essentially flat at $163 estimated, with a few days left, from in 2018, yet the market has soared about 30%. Clearly there were other things hampering investor sentiment in 2018, and those things generally, as I have outlined from time to time, were the Federal Reserve, which was tightening when it shouldn’t have; a global economic growth slowdown, and trade war between the U.S. and China, among other countries. All this appears to be behind us for the most part and because there was a bear market in the fall of 2018—on an intraday basis—the market has now reset, let’s say, to move on earnings from here, as it normally does. Hence, I believe that EPS will matter more in 2020, the opposite of 2018-2019. Indeed, the SPX EPS and price have roughly tracked each other since 2009, but as shown below, there are times where P/E led, and times where EPS led. Again, the last 2 years have been about P/E (de-rated in 2018, re-rated in 2019), but in 2020 and beyond, I view EPS being the key. I realize this is mere a “crude comparison” but in my view, 2018 was a proper bear market and a reset of economic and fundamental expectations. And while many date this bull market from March, 2009, I suggest that 2020 is in many ways Year 2 of a newish bull market, analogous to 2010. I stated at the start of this year that “2009 was the best analog for 2019” for U.S. equity markets, and I believe this remains correct. Thus, I see 2020 equity moves mirroring 2010’s (year 2 of that bull market), with some headwinds in the first half of the year. Where do I get my confidence that the entire year will be better? I think the Purchase Managers Indexes have bottomed and the 2020 global economy will be better than 2019’s drowsy growth. The leading indicators, such as the Economic Cycle Research Institute leading index and those global PMI indexes are all pointing to the same general picture: that the persistent economic weakness from mid-2018 through 2019 is ending and setting the stage for an improved growth outlook in 2020. The October ISM Exports posted a 50.4 print, a sharp rebound from September’s 41.0, lowest since the Great Recession. As shown on nearby table, each 1-point increase in ISM Exports adds 0.6% to S&P 500 EPS growth. The recent ISM reading of 50.4 is 9.4 points higher than September. History suggests the SPX EPS growth should rise by 545 basis points. I believe this recovery reflects abating of oil shock, weakening greenback and generally improving conditions. In a nutshell, I see in the next year reviving “Animal Spirits” as PMI indexes bottom, plus an accommodative Fed and potential fiscal support will equal EPS upside— and by extension an SPX rise. Bottom line: Given that, my forecast is for the SPX to reach about 3,450 (from about 3235 currently) in our base case, or a bit less than 18 times price/earnings ratio on that $178 EPS. My best case scenario is for $184 EPS, to which we apply an 18 multiple for a level of nearly 3600 on the SPX. Figure: Comparative matrix of risk/reward drivers in 2020Per FS Insight Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500** Performance is calculated since strategy introduction, 1/10/2019

  • Signal from Noise
Dec 26, 2019

2020 Could Be the Year "Animal Spirits" Return to Equities

– Strong equity return years—like 2019’s near 30%—often followed by good years – Another double-digit equity return expected, fueled by improving world growth – Tech, financials, materials, energy and industrial sector stocks should benefit Raise a glass if you have one handy —get one if you don’t—with just a few trading days left in 2019, the year will likely finish up as one of the best of the decade for U.S. equity investors, with a total return near 30%, as of Dec. 24. This is all the more remarkable since the 2010-2019 decade itself has been a robust one for stocks, too, up 182%, fourth best decade since 1900, according to Bespoke Investment Group data. Source: FSInsight, Bloomberg It’s the time of year when some pull out their crystal balls, but we use data here as well as history and good old-fashioned analysis. In 2020, I’m looking for the old bull to continue its yearend move to a nice canter from a leisurely trot, with the stock market rising at least 10%, as the EPS of the companies in the Standard & Poor’s 500 index (SPX) increase about the same percentage or perhaps better. SPX EPS should finish around $163 this year and estimates are for $178 in 2020. Indeed, while in 2019 the market’s price/earnings multiple carried the bull almost entirely—rising more than 25% to 18 times from less than 15 times on little or no earnings improvement—the market will have to produce the earnings growth that is expected of it, 10%, for the bull to continue rallying in 2020. It’s possible I’m underestimating the reviving “Animal Spirits,” which my colleague Tom Lee has alluded to in his recent “2020 Strategy Outlook: Reviving Animal Spirits,” Dec. 19. He has a base case SPX target of 3,450 based—versus about 3,235 currently—with a 17.9 price/earnings (P/E) multiple on estimated EPS of $193 in 2021.  That’s a number the market will be discounting 12 months from now.  While an 18 forward multiple is  higher than the 15 long term average, it’s interesting to note that this entire bull market’s (trailing) P/E has risen 50% from 2009, not atypical for bulls.  Valuations look particularly reasonable compared to bond yields below 2%. Let’s line up the various positives that undergird my call. The house forecast is for the global economy to pick up steam in 2020 from a languid 2019, and that should help SPX earnings grow. Purchasing Manager Indexes should recover and the easing trade tensions between the U.S. and China will support stocks. Meanwhile, China itself is showing signs of economic reacceleration. Additionally, earnings growth will likely get a boost from an improving inventory cycle, at a multi-year low. The Federal Reserve, a strong headwind in 2018, turned into a tailwind in 2019 when it began to reduce the Fed funds interest rate, and it should continue that way in 2020.  Unless the economy and inflation really ramp up, unlikely I think, the Fed has said it will remain on the sidelines next year, a plus. There will be potential easing of monetary conditions in Japan and Europe and all this could add 0.5% per quarter to U.S. gross domestic product, again benefiting profits growth. Perhaps the market is already discounting this, as in Q4 stocks of companies in the SPX with the most international revenue exposure have begun to significantly outperform those companies with mostly domestic sales.  By the way, materials and technology, sectors we think should benefit in 2020, have the most overseas sales. And what about those “animal spirits”? Until recently, this was a hated bull market, which ironically helped support it.  Finally, investor confidence, both institutional and individual, appears to be gaining, though we remain a long way from love or euphoria. I think that FOMO (fear of missing out) is just beginning to take hold and momentum is rising. This can last a while.  According to a recent Bank of America Merrill Survey, there has been a pronounced flip in fund manager expectations about the economy to a net +6% from -37% a month ago. This type and size change is unusual, particularly after extended negative readings. Similar past moves have only been seen at inflection points (to positive) in equity markets, such as 1998, 2002 and 2009.  Source: FSInsight, Factset  Individual investors, who have never really bought into this bull, seem to be getting more interested. According to , there were “impressive” ETF inflows of nearly $52 billion for the week ended Thursday, Dec. 19—the largest weekly inflow on record. Much of that went to equities. The year-to-date total is $342 billion, higher than the year ago inflows ($305 billion).  How different the picture is today from 12 months ago, when the market was coming apart at the seams, hitting an intraday bear market on Dec. 24, 2018. What about earnings? The nearby chart shows what industry analysts are projecting.  The energy sector, which we favor, is expected to report the highest EPS  growth, 21%, according to FactSet.  Industrials, another sector we like, is expected to report the second highest, 14.8%.  Additionally, SPX firms with more international sales exposure are expected to report higher earnings, 13.8%, relative to those with less, 7.6%. Many stocks are underperforming, even if they are up a lot.  The average SPX stock is up 26%, less than the index. Tech is up nearly 50%, but much of it is from Microsoft (MSFT) and Apple (AAPL), and there are even tech stocks that have underperformed.  Besides energy and industrials, we are recommending financials, materials and technology, for the long term.  While the U.S. is an overweight, by style cyclical and value stocks—which are more plentiful in Europe and China—are also expected to do better in 2020. Wall Street strategist surveys, a modestly good contrarian indicator, show a mean expectation of a 4% rise in 2020. Since 1928, nearly 80% of returns were higher than 10% or worse than -4%, so you should always be asking what might trigger the next big move, in either direction, says the Dow Theory Forecasts newsletter. Meanwhile, the NYSE Advance/Decline line is also at an all-time high and this often leads the market price by four to six months. Over the years, the odds are 85% that the market will be up after a double-digit return, points out Wellington Shields.  Indeed. A Happy New Year wish to all our clients and members. Where I could be wrong:  In terms of known knowns, the impeachment politics could turn uglier, or a radical leftist Democratic presidential candidate wins the presidency next November. Or the economic data somehow doesn’t improve, contrary to our expectations, EPS doesn’t grow and the recessionary boogeyman returns. Bottom Line:  2020 should provide a strong, double-digit return for equities. 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  • Signal from Noise
Jul 17, 2019

Earnings Recession Is Here! Look Thru It

-Investors worry SPX Q2 EPS comp could be negative -But 2020 10%+ EPS growth more important -Here’s a surprise: FactSet says 2Q EPS could turn out positive From a tactical view, knowing what’s expected quarter by quarter is de rigueur. After all, you need some ammunition for those cocktail party discussions. Moreover, the headlines are blaring “earnings recession,” that is, negative earnings per share results by the S&P 500 index in two consecutive quarters. Feels scary. (In the first quarter, the companies in the S&P 500 index produced a 0.3% decline in growth.) The last time the S&P 500 saw an “earnings recession” was 3 years ago during the second quarter of 2016. What headlines don’t mention is that since then the market is up by about a third. I’m giving you our heads up on the second quarter earnings season for the S&P 500 index, which began in earnest this week. Let’s qualify this immediately by noting that what investors are expecting in the way of 2020 market EPS growth is far more important by now—past the midyear point of 2019—than 2019’s second or even third quarter, though the latter are more immediate. The market discounts the future. What’s on tap for the second period? FactSet’s estimate for the second quarter S&P 500 index EPS is negative 2.7% compared to the same period last year. Why? Analysts are worried about the challenge of both tough comps in the second quarter of 2018 (which benefitted from lowered taxes) and from moderating economy growth this year, in addition to business uncertainty caused by the various trade wars, according to Zacks Investment Research. So, the EPS headwinds are there. And there have been some misses already, by, for example, Arrow Electronics (ARW) and CSX (CSX). Both stocks fell on the news. Before getting pessimistic, however, investors should note that what analysts project at the beginning of the quarter can be different both from what they expect at the end of the quarter, and—more importantly—what turns out to be the actual earnings. (See chart.) For example, at the beginning of the first quarter analysts projected a 4% EPS drop, but it ended up being better than that. That likely contributed some to the market’s rip in the first quarter. Veteran investors know that the Sell side—in aggregate—often exaggerates the market’s current sentiment. When investors feel bearish, the analysts tend to be too pessimistic on EPS estimates. Conversely, when sentiment is euphoric, analysts feel the mojo and often come up with EPS projections that are too high or optimistic. What about now? Sentiment seems to lean somewhat to the bearish side. Yes, it’s true the market is at or near historic highs. But let’s face it, there’s no sign of excitement and really this seems the most bearish bulls I’ve seen in 30 years. Few believe in it. To make an informed judgement about quarterly earnings, a little history is needed for context instead of screaming headlines. According to FactSet, over the past five years, actual earnings reported by S&P 500 companies exceeded estimated earnings by 4.8% on average, much of that because 72% of the S&P 500 reported EPS above their respective mean estimate. Consequently, from quarter’s end through the end of the earnings season, the earnings growth rate has typically increased by 3.7 percentage points due to the upside earnings surprises. Given that, FactSet asks—and so should you: What is the likelihood the index will report an actual decline in earnings of -2.7% for the second quarter? History suggests that isn’t very high. Instead, it’s likely the index will report positive growth in earnings for Q2. But wait, isn’t everyone afraid of an “earnings recession”? If this 5-year average increase is applied to the estimated EPS Q2 decline -2.7%, the actual growth rate would be 1.0%. I repeat, positive growth. I think it’s also interesting that during the second quarter, as the EPS estimates sank, the value of the S&P 500 increased by nearly 4.8% to 2941.76 from 2834.40. That marked the fifteenth time in the past 20 quarters in which the bottom-up EPS estimate decreased during the quarter while the value of the index increased. Seems like the bull doesn’t want to die. Bottom Line: Our head of research, Tom Lee, has a 3125 year-end target for the S&P 500 index and has said that might be too low. Our technical strategist Robert Sluymer agrees. I learned long ago that what the market already knows isn’t worth knowing. Investors know that earnings for the second and third quarters of 2019 are going to be lackluster, perhaps even negative. No news there. Now maybe they will be worse than expected, and that would tend to send markets lower, temporarily. Me? I’m focused on 2020. How about you?

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