Benjamin Lavine, CFA, CAIA
From the market closing low reached on 3/9/2009, the S&P 500 Index has achieved an annualized return of 17.45% versus 10.98% for ex-U.S. developed markets (MSCI EAFE) and 10.80% for MSCI Emerging Markets (Figure 1).
Figure 1 – An Impressive 10-Year Run for the S&P 500 Index
So, we must confess that this bull market feels tired, doesn’t it?
Yet, every time we think this run in the market has exhausted itself, it keeps finding the strength to push higher – despite investor anxiety over geopolitics, China slowdown, a tightening Federal Reserve, BREXIT delay, and growth malaise that Europe and Japan are struggling to shake off.
Over the long run, earnings drive market advances.
Strong earnings growth explains a large portion of this 10-year grind…at least in the U.S.; the rest of the world, not so much. Figure 2 shows the Bloomberg Consensus Earnings Estimates (white lines) next to the price indices for the U.S. (S&P 500) and the rest of the world (MSCI Europe, Japan, and Emerging Markets).
Figure 2 – Earnings for Me (the U.S.) but Not for Thee (the Rest of the World): Trendline of Earnings Estimates and Price Indices for Major Markets
Source: Bloomberg – 10-year weekly consensus earnings estimates (white line) vs. price indices for period ending 3/8/2018
And despite the dip in the earnings outlook towards the end of 2018, the picture is starting to recover for the U.S., flattening in Europe, but turning over in Japan and Emerging Markets (Figure 3).
Figure 3 – Earnings Outlook Stabilizing in the U.S., Not So Much the Rest of the World
Source: Bloomberg – 1-year daily consensus earnings estimates (white line) vs. price indices for period ending 3/8/2018
In Happy 8th Anniversary Bull Market, we wrote:
“Earnings anchor equity markets, and apart from the crazy late 1990s Internet Bubble, rarely do equities disconnect from the earnings picture. If the earnings picture were to falter, either because the current economic cycle finally gives way to recession or proposed fiscal stimulus/regulatory reform do not meet current expectations, then equities may succumb to gravity as earnings would no longer provide substantive support for further advances.”
Continued economic growth for earnings growth.
In turn, earnings growth relies on the long-term economic growth prospects of both the local and global economy.
For 2019 and 2020, Bloomberg consensus forecasts for real GDP growth in the U.S. are 2.5% and 1.9%, respectively – compared with 1.3%/1.4% for Europe, 0.8%/0.5% for Japan, and 6.2%/6% growth for China (although few outside the Chinese government know what is really happening in the Chinese economy).
Thus, the U.S. should continue to benefit from a higher market valuation – with S&P 500 trading at a forward 16x P/E versus 13.2x P/E for MSCI ex-U.S. Developed Markets (MSCI EAFE) and 11.8x for MSCI Emerging Markets – until we see economic growth converge between the U.S. and the rest of the world.
For now, the U.S. remains the best-looking house in a shaky global neighborhood still suffering from low nominal GDP growth due to high debt burdens, aging demographics, falling labor productivity, and excess global manufacturing capacity (i.e. New Normal Secular Stagflation).
Even so, equity markets can do well in a secular deflationary environment. But ‘growth stocks’ – whether high potential top line growth or high profitability – tend to prosper in an environment of growth scarcity. Think of a ‘rising flood’ where investors seek the high ground by bidding up scarce growth versus a ‘rising tide’ of cyclical growth and inflation, which can lift most boats (both high and low profitable).
The valuation gap is widening.
This bull market has definitely produced a ‘haves’ versus ‘have-nots’ – cohorts of companies enjoying high profitability and return on capital versus those that don’t, like old-line industrial cyclicals and highly levered financials competing on razor thin margins with little room for error.
Figure 4 is an updated chart with the price/book valuation gap between the Nasdaq 100 (the ‘haves’) versus the S&P Small Cap Value (the ‘have-nots’). (See last year’s.)
Figure 4 – Value’s Profitability Cannot Keep Up with Large Cap Tech (Nasdaq 100) – As a Result, the Valuation Gap Continues to Widen
Last year, we thought neither Nasdaq 100’s profitability nor valuation gap versus small cap value could widen much further from the extreme levels of late 2017.
In fact, the valuation and profitability gaps widened to new extreme levels, with the relative price/book gap reaching 4.5x at the end of 3Q2018, before reverting during the 4Q2018 sell-off.
Small cap value investors will likely continue to suffer until 1) competition erodes Nasdaq 100 profitability and/or 2) we enter a sustained cyclical recovery to give relief to lower profitable, smaller companies.
Earnings slowing down, but not contracting.
The 10-Year Bull Market may be showing its age with a slowdown in earnings expectations: Analysts now expect 4.1% earnings growth in 2019, according to the 3/1/2019 edition of Factset Earnings Insight.
Barring a significant macro-economic shock, the larger debate is whether the U.S. economy can continue to sustain low real economic growth beyond 2019/2020 and not fall into recession. A lot will depend on the global environment for economic growth and inflation.
Following the 4Q2018 sell-off, the Fed has said it will largely stay put on interest rates and slow down the pace of drawing down its balance sheet. They may even entertain letting inflation run a little hot before considering further rate hikes.
China has also announced fiscal and banking counter measures to stem a slowdown taking shape in its country, U.S. trade tariffs notwithstanding. In addition, the global financial system needs to avoid any major credit imbalances that could shake investor (and regulator) confidence; keep an eye on credit spreads in the U.S. for any signs of systemic weakness.
If the employment picture holds up and we see progress on global trade disputes, the global equity markets should resume their advance. World central banks have largely backed away from coordinated tightening, so the market should benefit from liquidity tailwinds and easier financial conditions.
Here’s hoping conditions lend themselves to at least an 11th year bull market.
Disclosure: The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete.
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