- Markets have bounced back nicely in 2019 after a volatile December, but this bounce has been driven almost entirely by multiple expansion.
- Earnings revisions have moved sharply lower, causing 1Q19 estimates to fall into negative territory. That said, estimates have likely fallen too far.
- The financial and healthcare sectors are expected to see positive earnings growth, while globally exposed sectors should struggle due to slower global growth and a stronger dollar. Meanwhile, lower oil prices compared to a year ago should weigh on energy sector profits.
- With effective tax rates now similar on a year-over-year basis, margins are no longer getting the artificial boost they did in 2018, and are expected to contract year-over-year due to rising wages and input costs.
- We prefer large cap over small cap, and cyclical value sectors that provide income and a more balanced total return profile.
The round-trip flight
The S&P 500 has risen 15.9% so far this year, putting the index on pace to return 70.1% in 2019. While solid returns to start the year were expected given the sell-off in December, trees do not grow to the sky, and it seems unlikely that this annualized return will be achieved. Furthermore, despite the fact that the Federal Reserve has paused its interest rate hiking campaign, better data out of China (in the form of the March PMIs) suggests that global growth may accelerate in the coming months, allowing long-term interest rates to move higher. If this is the case, it will limit the extent to which multiples can rise.
The reason why this is important is highlighted in Exhibit 1, which decomposes the S&P 500’s return from the end of 3Q18 through the end of 1Q19 into earnings growth, multiple expansion and dividends. Valuations led the market lower in December, and then rebounded back to average levels earlier this year as concerns over the trajectory of global growth have begun to fade.
Cumulative total return since 9/30/18 broken into earnings, multiples and dividends
EXHIBIT 1: THE BOOM AND THE BUST WERE DRIVEN BY VALUATIONS