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Animal Spirits

It’s the time of year for reflection, both on what has transpired—very good in markets if perhaps bumpy—and on what might be in 2020. For investors, it’s particularly important. Afterall, how does one follow up a stock market that has risen a white hot 25% in 2019. Can you top this? The way I read the economic data is that there are at least two keys to stock market action next year, and both lead to the potential revival of animal spirits. Let’s face it, we haven’t seen that kind of pro-market, enthusiastic sentiment in a long time, thanks to how painful the 2008-2009 bear market was. This bull is still not accepted by many investors but that might change soon and many investors remain gun shy. In my view, 2018 was a proper bear market—down 20% in December—and a reset of economic and fundamental expectations. So 2020 looks to me as Year 2 of a new bull market, analogous to 2010 after 2009’s sharp rise from lows. 2010 was ultimately a strong year but saw a weak first half. In summary, investors should not fight the central banks of the world, which are generally in an accommodative or non-hiking rate mode, a positive for stocks. (For more see page 6.) Second, the Standard & Poor’s 500 index aggregate earnings per share (EPS) will rise about 10% to about $178 from the expected $163 this year, according to FactSet. Given that, our forecast is for the SPX to reach about 3,450 (from about 3200 now) in our base case, or a bit less than 18 times price/earnings ratio on that $178 EPS. How we get there I’ll explain below. Our best case scenario is for $184 EPS, to which we apply an 18 multiple for a level of nearly 3600 on the SPX. EPS growth for the SPX should be much better than 2019’s flat earnings on 2018, with an acceleration due to, among other reasons, the anticipated recover in Purchasing Manage Indexes (PMI) both in the U.S. and globally. Given this paucity of growth in 2019, I also expect that in 2020 the E of the P/E will matter more. Additionally, earnings growth will likely get a boost from an improving inventory cycle, which is at a multi-year low, so inventory build should “boost” growth. Japan and possibly Europe could provide a fiscal stimulus to their consumers, and easing financial conditions should—according to Goldman Sachs—ad about 0.5% per quarter to the U.S. growth domestic product. And what about those “animal spirits?” Well, they might already be here according to the most recent Bank of America Merrill Survey, which shows 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. Take a look at the chart below. The move to a positive reading from -40 or worse has only been seen at inflection points (to positive) in equity markets, such as 1998, 2002 and 2009. (See chart below.) In each case, this was a sustained risk-on signal. To better understand my outlook, it might be useful to know the five guiding principles to my view. First, stocks are a “junior piece” to the capital structure and as such tend to follow other markets, leading indicators such as bonds, credit, derivatives and futures markets. Secondly, history is a useful framework, while demographics and generational factors are the least appreciated consideration by investors, even as they explain a lot of market dynamics. I have found that the consensus is often looking just one to 3 months ahead, and it often overreacts to incoming data. Remember, the market is a voting contest in the short term, assessing popularity, but a weighing machine in the long run, assessing substance. Bottom line: I see about a 10% rise in the SPX to 3450, as my base case. 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

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Illustrations by Karl Wimer.