Better 4Q19 EPS, Guidance, Economy Could Boost Market in 2020
Forgive me for harping on the “earnings recession” fears that have hung over the market for some time, but it pays to remember just how concerned most investors were 12-18 months ago. Now, however, this one-time bogeyman is in the process of likely resolving itself and fading away. That has implications for the bull market. (See Signal From Noise, Market to Focus on SPX EPS Growth after 4Q19 EPS Season, Jan. 15.)
I say this for a couple of reasons. Acknowledging right away that the fourth quarter 2019 results currently emerging are just a small sample of the entire Standard & Poor’s 500 index (SPX) companies yet to report, they are already better than forecasts.
Moreover, the better numbers are coming from important companies. As results continue to exceed the “EPS recession” analyst forecasts, I believe it will be enough to shrink equity risk premium, and create market upside.
O.K. Last week, the earnings seasons kicked off and for the 32 S&P 500 index companies that have reported thus far, 78% are beating and the average beat has been 2.4%. This is strong relative to both analyst and investor diminished expectations of down 1.5%.
I expect SPX companies to continue to mostly deliver results above lowered expectations, striking a generally positive tone for 2020 growth.
Let’s look at the numbers so far. These 4Q19 EPS results are pretty meaningful, with notable beats this week from JPMorgan (JPM) beating by 11.5% and 530bp on sales growth. Broadly speaking financials did well, with beats from Citigroup (C) +15.2%, Blackrock (BLK) +11.5% and Bank of America (BAC) +6.0%. But then cyclicals did well, too, as Delta topped expectations nicely (DAL) +22%.
The beats have been broad as both cyclicals and defensives have seen good results. The magnitude so far is nearly 5% ex-financials and ex-energy. It’s reasonable to think that the fact that some beats are greater than 10% (or +1,000bp) highlights the difference between diminished consensus expectations and the underlying better performance being seen, if only so far.
Guidance for 2020 is also positive given the fading headwinds of US-China trade war.
Economists see upside to 2020 GDP growth (See chart nearby). With the US-China signing the Phase I trade deal recently, overall visibility for companies and markets should improve and if there were significant drag effects in 2019, the combined effect should be upside to growth in 2020.
This is the rationale used by economists in modeling upside in 2020. An example is the work by Jan Hatzius at Goldman Sachs, with his model showing a drag of 40 bp/quarter in 2019 fading to 0 this year or 40 bp lift, which is substantial.
More support comes from the fact that financial and monetary conditions have eased so much that about 60% of leveraged loans are trading above par, a 14- month high according to JPMorgan’s high-yield credit team led. With strong pricing for bonds and tightening spreads, this should bolster CFO confidence, another factor for why 2020 guidance should be positive, in my view.
Now, combine these three points—4Q19 beats, better outlook and easing financial conditions—and you have a strong argument for the idea that the equity risk premium will fall in 2020.
Crucially, while SPX EPS is expected to grow about 10%, I think that the upshot of a strong 4Q19 results season is likely a further expansion of market’s P/E multiple, currently a bit more than 18 times.
A proxy for equity risk premium (ERP) is the SPX earnings yield less the U.S. Treasury 10-year bond yield. The current level, 3.4%, is well above the 30-yr average of 1.9%. The sensitivity table below shows comparative ERP levels and the associated implied S&P 500 price. If the ERP were to fall to 3.0% (40bp), this would increase the S&P 500 to 3,576 (+275 points) and as noted above, each 50 bps is worth about 2 P/E multiple points, or about 10% upside.
What could go wrong? A systematic shock like a geopolitical event could cause business visibility and investor confidence to collapse.
Bottom line: I expect a strong 4Q19 EPS results season (playing out so far), with the resulting impact on equities being a further decline in equity risk premium. I think stocks are in the process of seeing a decline in ERP from elevated levels (3.4% is near the 1-standard deviation high of 4.2%).
The following 20 stocks (1) currently have an above average ERP, (2) are estimated to have a YoY EPS growth in 2020, and (3) are highly ranked in Fundstrat Quantamental model. The tickers are BWA, F, GM, PHM, NCLH, EBAY, HOG, ARNC, SNA, JNPR, INTC, HPQ, NTAP, LYB, EMN, COF, SYF, KEY, MTB and DISCA.
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, 1/10/2019
