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In my previous missives about 2020, I outlined our market view from 30,000 feet, so to speak, that our base case outlook is U.S. stocks rise 10% plus—to about 3450 on the Standard & Poor’s 500 index. This is predicated on index earnings growth of about the same amount or better this year. Let’s dive deeper now and see what styles, sectors and stocks I believe might work in this new year. My basic longer term-premise is that investors should overweight value and cyclical stocks, for reasons I’ll enumerate below. In particular, I favor technology, industrials, energy and basic materials sectors. In general, my themes for 2020 include the following: Overweight American stocks, as the U.S. decouples from the rest of the world Overweight technology, as technology/industrial companies will supply “nonhuman” labor and increase productivity Overweight asset heavy companies, as coming reflation will hurt those “subscription” asset light models and boost asset heavy models. Overweight companies exposed to the Millennial generation, as this bulging demographic cohort will be the primary driver of credit expansion in the future. And, in general, overweight value stocks versus growth, because we expect that as economic growth improves it will become a rising rate world, and history suggests that value beats growth in that environment. The base case for our “EPS is key” outlook is a recovery in 2020 EPS growth towards double-digits, as I noted in last week’s piece. The deep cyclical sectors are driving this recovery, led by technology, industrials, energy and basic materials. Collectively, these sectors are forecast to be more than 45% of the SPX’s EPS gains in 2020, so it’s pretty crucial to the thesis. Let’s look at history. Since 1949, whenever Purchasing Manager Indexes recover to above 50 level, as we expect, cyclical and value stocks have done well. More interesting, in the last 25 years, 3 groups consistently outperform in that scenario: technology, energy, among sectors, and value, in style. Why does value tend to outperform when the PMIs recovers above 50? The composition of the Russell 1000 Value Index, for example, could explain this. The “deep cyclical” sectors that are most sensitive to change in economic condition – the aforementioned industrials, materials and energy—represent some 21% of that Value index. Additionally, technology (including communication services) and financials represent more than one third of the Value index. They are the best performing sectors when PMIs rise above 50. The U.S. manufacturing sector contracted in December, thanks mainly to trade tensions. The Institute for Supply Management said on Friday its manufacturing index fell to 47.2 in December from 48.1 in November. The PMI is still in the process of bottoming and, as I’ve noted in the past, the UST 10-year-30-year bond spread suggests PMIs will recover later this year. On the other hand, the S&P 500 index has a higher mix of ‘high margin” or “high value” sectors such as technology and healthcare and has the lowest share of “deep cyclicals” like industrials, energy and basic materials. As a sidelight, I’d add that the inventory cycle is adding a little “oomph” to the PMI recovery. A factor supporting the bottoming of the industrial cycle (and hence, upside to 2020 growth) is this potential reversal of the previous inventory destocking. Another positive supporting stronger EPS growth in 2020 is that financial conditions continue to ease and markets stand at the best financial conditions since March 2018. The Goldman Sachs Financial Conditions index shows that financial conditions have eased in the past few weeks. (See chart below.) One thing not generally considered by investors is the turnover inside the S&P 500 index and what it means. Newly added companies will drive 23% of gains in S&P 500. Notably, my confidence in the future gains in the S&P 500 is driven by the realization that new companies will produce a meaningful share of gains. More than 23% of the return of the S&P 500 within any 10-year period is derived from companies added within the prior 10-year period. For example, in the last decade this has included new profits from Google (GOOGL), Facebook (FB), and Twitter (TWTR). 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.

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