- The sharp growth in stock valuations in 2019 surprised many since earnings growth was flat—but, in fact, that is a common occurrence around inflection points.
- My base case for 2020 is decent earnings growth and an average year for the US stock market.
- But a delay in the earnings rebound, perhaps due to China's coronavirus outbreak, could result in a stock market pullback.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
The US stock market's strong rally in 2019—driven by a 33% expansion in the price-earnings (P/E) multiple amid only 1% growth in earnings—has many bull-market skeptics moaning once again that the "everything bubble" is about to burst.
But I see a potentially more bullish outcome for 2020: decent earnings, perhaps combined with some multiple contraction, producing an average year for US stock market returns.
Valuations and earnings: trading places?
It's certainly true that the S&P 500® ended the year more pricey than it began, and the index is indeed more expensive than it has been in some time. Reviewing data back to 1871, the S&P 500 index is now in the 88th percentile for valuation on a last-12-months P/E basis. Quick reminder—the P/E ratio, or multiple, shows how much investors are willing to pay for $1 of earnings.
But what the bears fail to note is that 2019 was the flip side of the year prior: 2018 earnings soared 22% and the P/E ratio dropped 28%. This type of action can often happen at inflection points because the market is a discounting mechanism, meaning it looks ahead.
Historically, stocks have tended to alternate periods of P/E multiple expansion with periods of earnings growth—and rarely the twain shall meet. In other words, as earnings per share (EPS) goes up, the P/E multiple may fall—and vice versa.
With valuations as they are, if the earnings growth recovery doesn't turn up, the stock market risks finding itself out over its skis. Fortunately, earnings growth may indeed be close to a bottom (thus potentially preparing for a rebound) following the slowdown of 2019, as shown in the chart below.
FactSet's most recent S&P 500 earnings estimate for 2020 stands at $175. As often happens, the earnings estimate started out way too high 12 months prior, at $186. Over the past year or so, the estimate descended right in line with the typical downward drift drawn by the passage of time to connect with actual earnings reports. Based on that historical drift, the most recent estimate has another dollar or so to drop, to around $174, by my calculation.
With 2019 actual earnings likely ending somewhere near $160 per share and what I perceive as an imminent earnings bottom, EPS growth mathematically should rebound to around 8% in 2020. If we achieve that, then even if we see some compression of the valuation multiple, I'd think the stock market would be able to post a mid-single-digit return for 2020. After the S&P 500's 32% run-up in 2019, I'd take that as a win.
What to watch: Earnings and the dollar
Although earnings estimates usually drift down over the course of a year, they can also reverse as a cycle turns. While such a turn is not my base case, a drop in the US dollar—which I think possible as long as the Federal Reserve keeps adding excess reserves to the banking system—could stir things up. A dollar decline could boost corporate revenues down the road (with a lag of perhaps several quarters), which likely would find their way into higher earnings.
Thus, I think earnings and the dollar are likely to be key drivers in 2020. And who would benefit? With a gain in the former and a decline in the latter, I think chances are that 2020 could generate excess returns for non-US equities—in particular, emerging-market equities—much like what happened in 2017, although probably on a smaller scale given China's more modest stimulus this time around.
The bearish case
What could derail this scenario? Lofty valuations don't tend to revert to the mean all by themselves. They need some downward catalyst. Could geopolitics provide the impetus? Higher interest rates? China's new coronavirus? The November elections?
The dangerous coronavirus now flaring up in China is one of those impossible-to-anticipate "left tail" events, and the magnitude of the virus's impact on global growth and corporate earnings is unknowable in real time. Natural disasters—including viral outbreaks—historically have tended to have only a temporary effect on economic activity. For example, previous coronavirus-type outbreaks such as SARS (severe acute respiratory syndrome) in 2002 and MERS (Middle East respiratory syndrome) in 2012 may have interrupted prevailing trends, but they didn't change them. It's too early to tell but one potential outcome of the 2019 coronavirus is that it may simply delay the earnings recovery already underway.
Nevertheless, with the stock market priced for a global rebound, even a delay of just 1 or 2 quarters could cause a P/E-multiple compression of several points. In the absence of positive earnings growth, that alone could knock 5% to 10% off the S&P 500.
The Fed factor
What about the US Federal Reserve? After 3 cuts last year, I think the Fed's made it clear that it's out of the picture unless either the economy weakens significantly (rate cuts!) or inflation makes a sustained comeback (rate hikes!). I don't find either scenario likely in the near term, and thus I suspect the Fed will indeed keep to the sidelines this year. Indeed, this is more or less what the Fed announced at its most recent Federal Open Market Committee (FOMC) meeting. But with the yield curve flattening once again in the wake of the coronavirus, I suspect that the Fed is on the lookout for signs of deteriorating fundamentals.
My bottom line
If we can avoid a downward catalyst and get decent earnings growth, I foresee a year of average returns for US stocks.