As one who has written more than fifty year end letters to clients and friends, I can attest with total confidence that most of these efforts are exercises in futility. Rarely do Wall Street pundits, myself included, correctly predict the course of stock and bond prices in the year ahead. When our forecasts do turn out to be correct, more often than not, it is due to factors that were not considered at the beginning of the new year. In simplest terms, the direction and extent of equity prices next year will not be a linear move. The stock market’s overall trend will depend on the rate of increase (or decrease) of corporate earnings, the overall rates of inflation and interest rates, the initial and projected year-end valuations of stocks and bonds, as well as the degree of surplus financial liquidity, i.e. the growth of the money supply (M2) compared to the growth of Nominal GDP. All one can do at the beginning of the year is to outline a base case, with the understanding that investors must be quick to revise their thinking should changing circumstances demand it. Needless to say therefore, one must begin with a number of assumptions.
The U.S. economy is on track for another year of modest expansion, as the sum of labor force growth plus the increase in productivity – real GDP – is likely to increase at about a 2% pace, give or take. Any higher number would require a surge in productivity, a recovery in capital spending, or in net exports. The latter will depend greatly on the trade-weighted value of the dollar, and on an economic recovery in China, the EU, and Japan. We will remain alert to these possibilities, but for now, our base case is for 2% real GDP growth.
Inflation is unlikely to reach the Fed’s 2% target, as the three “3 D’s,” debt, demographics, and disruptors will continue to keep a lid on prices, along with competition from cheap imports from the emerging markets to the U.S. Therefore, overall profit growth for the S&P 500 Stock Index will be restrained and will be driven by a relatively small group of large growth companies dominated by defense, tech, healthcare and social networking. Thus, our base case for S&P 500 profits is for a mid-to-high single digit increase against a backdrop of restrained pricing power and low inflation. Under these circumstances, the Federal Reserve’s Open Market Committee (FOMC) is likely to remain on hold for 2020, so overall short term interest rates should remain low and support at least current equity valuations. Any increase in P/E’s would require a more rapid growth in money supply plus expectations later in the year that the expansion will continue into 2021. Notwithstanding the Fed’s recent injections of liquidity into the overnight money markets, we would not expect money supply (M2) to accelerate from its most recent torrid pace, which we view as temporary.
As the year comes to an end, the S&P 500 at about 3200 seems fully valued based on trailing earnings. Even assuming an increase to $180 in 2020, the forward P/E is just below 18. This represents a 5.6% earnings yield, and compares with BBB bond yields just short of 4%. Thus, stock prices should be able to advance in line with earnings, but are unlikely to do much better. Since the financial crisis of 2008, investors have been selling stocks and adding to their holdings of bonds. If this trend were to reverse, there could be a speculative blow-off of equity valuations. This is not our base case, however.
While these assumptions, incorporated into our base case, seems reasonable at this time, one can be sure that there will be other factors, some related to domestic politics, others related to larger geopolitical events and still others we cannot imagine at this time. All in all, we are coming off a year of nearly a 30% gain in the S&P 500. While the critical factors discussed above seem likely to continue, it is a real long shot to expect a similar gain in equity prices next year. Indeed, history suggests that after a year of enormous gains, the early part of the new year will see a short-lived but significant correction. As a final note, with the 10-year Treasury bond providing a yield of 1.90%, there is a significant risk, that even with the modest growth we are projecting, that yield will not remain this low. As an example, a move to a 2.5%-3.0% 10-year yield would trigger significant losses to bondholders.
