- 2019 was a good year for equities as multiple expansion drove stock markets to new all-time highs.
- 4Q19 earnings look solid relative to a year earlier, but this is largely due to a disappointing 4Q18.
- The financial, technology and communication services sectors likely saw earnings grow; energy, industrials, materials and consumer discretionary earnings appear to be under pressure.
- Operating earnings seem to provide the cleanest read on corporate profitability; stable profit margins will be key for earnings growth in 2020.
- A focus on total yield (dividends + buybacks) should allow investors to maintain a cyclical stance while simultaneously muting volatility.
Going out with a bang
Equity markets finished 2019 on a high note, as a combination of easier monetary policy and cooling trade tensions lifted investor sentiment1 to its highest level since February 2018. Nearly all of the equity market gains seen last year were a function of rising valuations; fears that drove the sharp sell-off at the end of 2018 failed to materialize, which allowed valuations to expand well above long-run averages. Overall, multiples were responsible for 83.7% of total returns in 2019, while dividends and earnings were responsible for 8.3% and 8.0%, respectively (Exhibit 1). However, taking a step back and looking at performance attribution over the past two years, earnings were the main driver of returns.
Operating earnings growth was mixed during the first three quarters of 2019, with mid-single digit growth in the first half of the year and a slight contraction in the third quarter. The third quarter contraction should not have come as a surprise, as 3Q18 saw both earnings and profit margins hit their cycle highs. 4Q18, however, was not friendly to corporate profits. An accounting rule passed in 2016 requires companies to mark their equity holdings at fair value each quarter and apply any gains or losses to net income; this ravished the profits of some financial services companies, leading aggregate earnings to decline sharply at the end of 2018. The good news, however, is that this created a favorable base effect for the 4Q19 earnings season, supporting our expectation that earnings growth will be positive on a year-over-year basis. Currently, with 19.9% of the market cap having reported, our estimate for Q4 2019 is $39.49, which represents a 12.7% year-over-year growth rate.
EXHIBIT 1: 2019 returns were driven primarily by multiples
S&P 500 total return broken into multiples, earnings and dividends