In our Labor Day Eye on the Market, I concluded that rising Fed policy rates, the end of central bank intervention (see accompanying chart), U.S. import tariffs,1 slowing growth outside the United States (particularly in Europe2), rising U.S. budget deficits and elevated levels of market concentration in a handful of tech stocks would cause equity P/E multiples to contract. What I might have underestimated was by how much they would contract, and how these forces would offset continued U.S. earnings growth and stock buybacks.3
Part of the investment discipline at the end of business cycles is to understand what such periods look like. One critical question is this: How much lead time do investors have before asset prices peak? When the last two business cycles ended, corporate earnings, economic growth and equity markets all collapsed at roughly the same time.4 As a result, if earnings growth looked good, the cycle still had legs. But in the five business cycles before the last two, equities peaked around a year before economic growth slowed, and before earnings started to materially weaken. If so, what we are now witnessing could be the final stages of what has been one of the best-performing U.S. equity markets since the Great Depression in the 1930s.5
In July of this year, I gave an interview to Barron’s, which cited the risks mentioned above as reasons to start playing more defense in portfolios.7 To be clear, the 9.5% S&P 500 correction since August 2018 has taken some of the steam out of extended U.S. equity valuations, which have fallen from 17x to 15.5x 2019 earnings estimates.8 I also expect U.S. equity markets to rebound a bit after such a steep decline, as they did after the 10% selloff last February. Nevertheless, a reflexive “buy the dip” mentality, which worked so well during the 16 corrections of 6% or more since 2009, appears less compelling right now.
1Tariffs. The next round of tariffs on China will have a bigger impact on U.S. consumers than the prior two, given the shift in targeted products from capital goods and intermediate goods to consumer goods as well.
2Europe. European leading indicators are weakening, and the Q3 European earnings season got off to a weak start with only 23% of companies beating expectations. Looking at earnings beats and negative earnings revisions, Q3 may be the worst earnings season in Europe since Q4 2008. As illustrated in the September 2018 Eye on the Market, overweighting U.S. equities relative to both Europe and Japan has been the most rewarding asset allocation strategy that I have seen in my 30 years at J.P. Morgan, including another large U.S. outperformance gap again in 2018.
3U.S. earnings and buybacks. We currently project 8%–10% S&P profits growth for 2019, although there is some downside risk to this number as tariff impacts become clearer. Most projections we have seen indicate $800 billion to $900 billion in U.S. stock buybacks in 2019, following ~$700 billion this year.
4Economic growth. For purposes of tracking when the U.S. economy “turns,” we use an indicator that combines the unemployment rate and manufacturing capacity utilization.
5History of bull markets. Since the recovery began in March 2009, the price-only return on the S&P has been ~14% annualized, a nine-year return that has only been matched a few times since 1940: in 1956, 1958, 1987, 1989, 1991, and during a longer stretch at the end of the 1990s.
6We will discuss this chart in greater detail in the 2019 Outlook. The bottom line: Both developed and emerging economy central banks have been intervening and buying G4 assets aggressively since the year 2000; the former for quantitative easing purposes since 2008, and the latter to prevent unwanted currency appreciation to build a stockpile of FX reserves for rainy-day periods. Both of these trends are now coming to an end.
7See “It’s Time for Investors to Play Defense,” Barron’s, July 17, 2018.
8Using quarterly IBES projected operating earnings since 1985, the current 15.5x US P/E multiple still ranks at the 65th percentile vs. history, and that’s assuming 10% earnings growth in 2019 following 20%+ earnings growth in 2018. During the recent correction, the hardest hit sectors in the United States include those sensitive to rising interest rates (homebuilders, companies with high dividends), the strong dollar, and declining globalization (companies with high foreign sales) and crowded trades (the FANG stocks). Over the medium term, pressures on earnings are likely to mount due to rising U.S. labor, interest and credit costs, fading globalization, and an eventual decline in financial engineering through share repurchases.