U.S. Equities: Late-cycle defenseContributor David Lebovitz
On the surface, 2019 has been a solid year for the U.S. equity market, with the S&P 500 up over 25% through the middle of November. To an extent, this is a function of the starting point, as stocks sold off heavily into the end of 2018. That being said, equity markets have hit new all-time highs, as multiples have expanded on the back of waning geopolitical uncertainty and third quarter earnings that came in better than expected. Beneath the surface, however, the fundamentals are showing signs of deterioration — earnings growth has slowed, profit margins are under pressure and the pace of buybacks has come off the boil. As we look ahead to 2020, we foresee modest profit growth and a stock market that grinds higher, but downside risks are building.
The S&P 500’s forward price to earnings ratio currently sits at around 17.5x, near the higher end of its recent range. With markets already pricing in material progress on trade, it is difficult to see how significant multiple expansion can continue. Given this expectation for range-bound valuations, earnings look set to be the main driver of returns next year.
S&P 500 Index: Forward P/E ratio
EXHIBIT 7: Price divided by consensus analyst estimates for earnings over the next 12 months
Source: FactSet, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management. Price to earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months as provided by IBES since November 1994, and FactSet for November 26, 2019. Average P/E and standard deviations are calculated using 25 years of IBES history. Data are as of November 26, 2019.
2019 has seen a slowdown in earnings growth, with margin contraction weighing on the headline figure. But what does this mean for earnings in 2020? The pace of buybacks has slowed, and it seems reasonable to expect this to continue next year. At the same time, revenue growth has been and will continue to be limited by low rates of inflation, trend-like U.S. economic growth and still slow growth overseas. Margins have been contracting throughout 2019, and are now nearly a percentage point lower than a year ago. Consensus estimates are for 9% earnings growth in 2020, driven by an assumption that profit margins will expand north of 12%. But given a backdrop characterized by low unemployment, modest wage growth and moderate revenue growth, it is difficult to see how this might materialize.
Consensus estimates will fall in the coming weeks. The question is, will they fall enough? Our top-down earnings model currently projects profit growth of around 1% next year under the assumption that profit margins fall to a level of 10.6% by the end of 2020. However, if we assume that margins are a bit more resilient, and hover around 11% over the course of the year, our forecast improves to 2.5%. Regardless, these numbers are well below consensus estimates, and the risks are tilted to the downside.
S&P 500 year-over-year operating EPS growth
EXHIBIT 8: Annual growth broken into revenue, changes in profit margin & changes in share count
Source: Compustat, FactSet, Standard & Poor’s, J.P. Morgan Asset Management. EPS levels are based on annual operating earnings per share. *2019 & 2020 earnings are J.P. Morgan Asset Management forecasts. Percentages may not sum due to rounding. Past performance is not indicative of future returns. Data are as of November 26, 2019.
Given a backdrop of sluggish, but positive, earnings growth, how should investors position equity portfolios? Volatility tends to be higher in election years than in non-election years, and we see no reason why 2020 should be any different. Given this, we continue to focus on quality and total yield (dividends + buybacks) in an effort to mute some of this projected volatility. This leads us to sectors such as technology, financials and energy, with the more value-oriented sectors also commanding a valuation advantage. On the other hand, defensive bond proxies continue to look expensive. With recession risk contained, we continue to balance cyclicality and yield, and believe a combination of the two will drive an optimal outcome for investors.