Large Cap Commentary-December 2018
As a child I remember seeing ‘It’s a Great Pumpkin, Charlie Brown.’ In it, Charlie Brown would compare with his friends what he was given as they went door to door on Halloween. At each house Charlie Brown’s friends would get different pieces of candy. Invariably, Charlie Brown would get a rock. Maybe I am mixing my holidays, but in December it felt like Santa gave us and the market a rock.
In addition to a drubbing for stocks, volatility rose, but the bad kind of volatility. Concerns over global economic slowing increased. The Chairman of the Federal Reserve, Jerome Powell, spooked the market as he explained Fed policy. Vitriol around trade and tariffs made headlines. The list of negatives seemed to grow by the day. It was a painful way to end what became a painful year.
The script for 2018 was not supposed to turn out this way. Earnings to date have grown by over 20%, helped a great deal by changes in corporate tax rates. Sales have grown as well. Growth in sales and growth in earnings usually are good ingredients for upward movements in stock prices, but that was not the case in 2018. Instead, investors took a much more ‘the glass is half empty’ outlook, especially after the midpoint of the year. While it was fair to expect slower growth in 2019 and 2020 off of 2018 sales and earnings, a slowdown does not a recession make. It was recession that seemed to be more and more on the minds of investors as the year drew to a close and each day in December passed.
To be sure expectations are just that, expectations. No one has a crystal ball to see into the future. But there are a good number of market watchers who spend a great deal of time analyzing trends in the economy, in corporate sales and earnings, etc. and who produce estimates for the market. To date, consensus expectations for the market in 2019 are for sales to increase by 6.2% and for earnings to increase by 7.4%. Not a great number, but not too shabby coming off a year like 2018, where earnings are expected to rise by 22% and sales by nearly 9.5%. In addition, expectations for 202 are for earning to grow by 11%, with sales up to over 4.5%. Admittedly, a larger grain of salt is required as estimates push further and further into the future. But the primary takeaway from my perspecitve is that market watchers expect up earnings and sales for both 2019 and 2020. That is the antithesis of a recession.
So, with that as a backdrop, how does the market look in terms of valuation? Using our tried and true Rule of 20, that says the forward price-earnings ratio of the market should trade at 20 minus the yield of the 10 Year U.S. Treasury bond, the market should be paying 17.3x for each dollar of earnings in 2019. Instead, the S&P 500® Index is trading at 14.2x forward earnings, or a discount of nearly 20%. While it’s fair to say earnings for 2019 may come down given all of the uncertainties in the markets and global economies today, I would argue that a 20% discount to fair value represents pretty good odds. We will see how the year plays out.
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Senior Portfolio Manager