Winds of Change

2019  Outlook: Winds of Change

Tailwinds of tax cuts and strong earnings shifted to headwinds of trade tariffs, global economic slowdown and tighter monetary policy in 2018.  What does it mean for 2019?

U.S. Stock Market

Gauging the investment and economic climate is always challenging—at least it has been for me over the last 35 years. But, ’tis the season!  It is with every new year that economists, research analysts, market experts and my type, portfolio managers, offer their outlook and forecast for the year ahead. 

Even as this year’s theme is Winds of Change, the truth is, the weather is easier to forecast than the stock market.  While I wouldn’t trade my job to be a weather man, the weather’s wind predictions might have a higher success rate than foretelling the changing winds moving the stock market. With that, back to my job.

This is my outlook for the U.S. stock market in 2019, along with a view of the U.S. economy.  My 2019 outlook for the global markets and economy will appear in ALIVE next month.  

What I know…

In March, the bull market we have enjoyed turns ten.  It is the longest bull market in history.  It is instructive to remember what Sir John Templeton said about bull markets.  “Bull markets are born out of pessimism, grow on skepticism, mature on optimism and die on euphoria,” he said.  Euphoria is an emotion that leads to greed and excess. That makes for the most helpless animal of the Wall Street bunch; pigs.  According to the Chinese calendar, 2019 is the Year of the Pig. Coincidence?  Essentially, bull markets don’t end of old age; they end with piggishness. Let’s remember, “Bulls can make money and bears can make money, but pigs get slaughtered.” That old Wall Street sage sounds grim, but it’s true. So, let’s not be the pig.

We know that investor sentiment, a key psychological indicator of the stock market, is far from euphoric. In fact, the “Bull/Bear Barometer” has flashed decreasing bullish and increasing bearish sentiment since early October. This development is good; it’s bullish, from a contrarian perspective.  Simply put, in contrarian thinking, bad is good and good is bad. Therefore, it is bullish that market sentiment has recently turned bearish.  What caused the market sentiment swing that began in early October? The tailwinds of tax cuts and strong earnings shifted to headwinds of trade tariffs, global economic slowdown and tighter monetary policy. We also know stocks’ historically strong post-midterm-election performance trend is a tailwind, but mounting trade uncertainty and the political landscape have created offsetting headwinds. Discipline around diversification and rebalancing will be important in 2019. Recession risk is rising, and we know stocks historically have posted their weakest performance during the six months leading up to recessions.  Over the last 50 years, U.S. equities have never peaked more than 13 months before an economic recession, so if we learn in the near term that the market topped with its October highs, the next recession is no sooner than late 2019. 

What I think…

Earnings will be key. I expect earnings growth to decelerate sharply in 2019.  Year-over-year comparisons will be more challenging relative to the tax-cut-related boost 2018 earnings received. Last year’s fourth quarter volatility was in large part driven by a growing conviction that 2018 would be “peak” earnings for companies. Also, I see the continued strength in the U.S. dollar and the impact of trade tariffs imposing additional headwinds for earnings, even though stock valuations have become more reasonable as prices have dropped. The winds of change affecting the market will further influence investor sentiment, which is likely to move the stock market in 2019, as volatility persists. As I write this 2019 OUTLOOK, the major U.S. stock indexes are struggling to recapture key support levels. After slicing through their respective 200-day moving averages, the major market indexes have attempted—and twice failed—to climb back above those meaningful levels. Having clearly fallen enough to be in “correction” mode, the looming question is: will the U.S. stock market fall further into the throes of a bear market? I don’t think so. With the notion that bull markets do not simply die of old age, as a strategist I think it is too early to become overly defensive given that 2020 seems the recession danger zone. Ultimately, stock prices are all about earnings. Adopting the consensus view, I expect earnings growth to drop significantly from last year’s growth rate. With a forecast of 9% earnings growth for the S&P 500 in 2019, I have a price target of 3000 for the major index—not bad from the current level of 2600 in mid-December, but for proper perspective, only a 2% price gain from 2940 in early October. Do the potential returns justify the risks? It’s the most fundamental investment question. I think they do. Again, as said above, discipline around diversification and rebalancing will be important in 2019 to contend successfully with the winds of change.

The U.S. Economy

As some think 2018 was a peak earnings year, some also think the U.S. economy is now as good as it gets for the cycle. Real GDP growth in the middle quarters of 2018 logged north of 3%, roughly double the estimate of the U.S. economy’s long-term potential at the year’s start. Earnings growth for the S&P 500 index has been 25% or higher in every quarter this year (through Q3) – a remarkable rate seen usually when coming out of recessions. And, the unemployment rate stands near a 50-year low. U.S. fundamentals are unequivocally strong right now.

• Interest Rates: 1 & 4, or 1 & no more?  The inference is, will the Fed raise their key federal funds rate one more time in late December, as they have signaled, and hike four more times in 2019, or will they raise one and be done (with no rate increases in ’19)?  That’s the great debate over the Fed’s target interest rate.   Certainly “ZIRP” (zero interest rate policy) is a thing of the past as the Fed has raised rates eight times since December of 2015. Many believed through most of 2018 that the Federal Reserve was on a mission to get interest rates to normal levels. ZIRP was far from normal and so is today’s still low rate level. Interest rates in the United States averaged 5.70% from 1971 until 2006, reaching an all-time high of 20% in March of 1980 and a record low of 0.25% in December of 2008. As I write this is mid-December, I see the Fed’s playbook as “1 + 1 = done”.  They will hike rates late December 2018 and at the June 2019 scheduled FOMC meeting. The wild card?  Chairman Jerome Powell & Co. at the Fed decide NOT to raise in December…

• Inflation:  Labor costs are the biggest component of inflation in the U.S. With unemployment near 50-year lows, labor costs can only go up. Expect this in 2019, and inflation pressures to ensue. As I said this time last year, the jobs market is just too strong for another year of below average inflation measured by the CPI (Consumer Price Index). Historically, inflation has averaged about 3.2%. As of late 2018, the “core” rate — all prices except food and energy — picked up to a 2.2% yearly rate. This rate will likely edge up to near 3% by the end of 2019 as the economic expansion generates small inflationary pressures, the healthy jobs market being the catalyst. Speaking of health, U.S. health care inflation rate was at 2.03% (2018), compared to 1.68% last year (2017). This is lower than the long-term average of 5.32%.  Expect inflation approaching 3% in 2019. 

Look for Part 2 of my 2019 Outlook: Global Markets and Economy, in February’s ALIVE Magazine. 

HAPPY & HEALTHY NEW YEAR! 8Z