2019 Market Outlook
Research Market & Economic Outlook – 2019
Volatility returned to the equity markets in 2018, as investors endured two double-digit percentage market corrections, both preceded by market rallies. This created a tale of two markets in 2018. The year’s first market, from January to September, included a January surge to new highs followed by a 10% correction in early February. By late September, on the back of impressive U.S. GDP and earnings growth, the S&P 500 rallied to new highs and a year-to-date (at the time) gain of 9.6% at its peak. At that point, the year’s second market kicked in with the beginning of a more severe correction that remains underway and includes the S&P down 13.5% from its September high. Investor sentiment has turned decidedly negative due to fears of economic slowdown in the U.S. and internationally, an uncertain deceleration in earnings growth, an escalating trade dispute with China, and Fed tightening that many believe is overly aggressive. These fears should not be dismissed and are likely, in our view, to drive continued volatility in 2019. However, with the S&P 500 down 2.8% year-to-date, despite 25% earnings growth, equity market valuations are much lower today than one year ago and appear to be pricing in economic headwinds that may not fully materialize. This valuation support, along with expectations for 2019 growth in U.S. GDP and corporate earnings, leads us to conclude that equities can move higher in the year ahead. Our target for the S&P 500 at year-end 2019 is 2,900, which represents an approximate 16% gain from recent price levels. Adding to that an estimated dividend yield of 2% for the index produces a total return expectation of 18% for 2019. While our target appears aggressive given the ongoing market correction, our price target is below the market highs of September 2018.
Our price target represents a P/E of 16.7x the current FactSet consensus 2019 EPS estimate for the S&P 500 of $174. This is slightly above the 20-year average S&P 500 P/E of 15.7x, which we view as reasonable given that long-term interest rates remain well below long-term averages. The 2019 EPS estimate reflects a year-over-year (y/y) increase of 8% from 2018 estimated earnings, which (with Q4 still to report) are expected to grow 22% from 2017. We estimate that the Tax Cuts and Jobs Act (enacted at the end of 2017), which lowered the statutory U.S. corporate tax rate to 21% from 35%, added approximately 7% to S&P 500 earnings growth in 2018. While the lower tax rates and positive contribution to earnings will continue in 2019, the percentage boost to the growth rate will not. Excluding the tax reform benefits, we estimate that S&P 500 earnings increased 18% through Q3 and will grow 15% for the full year, reflecting strong corporate performance and full-year results well above prevailing estimates in early 2018 (in April 2018 the S&P 500 consensus EPS growth estimate was 18%). In our 2018 Market Outlook, we published a 2018 S&P 500 target of 2,850; we subsequently raised that target to 2,975 after GDP and earnings trends were exceeding expectations. The market peaked at 2,931 (closing price) on 9/20/18, and since has endured a steep correction of greater magnitude than we expected. Through 12/14/18, the S&P 500 year-to-date (YTD) decline was 6.2% on a price basis and -4.40% including dividends. In Q4 alone, the S&P 500 price decline is 14.0%.
2018: The Return of Market Volatility
On average, the S&P 500 experiences a correction each year. It did not take long in 2018 for investors to be reminded that equity prices can be volatile and that market corrections are possible. After setting 15 new record highs in January, the S&P 500 peaked on 1/26/18 then declined 10.2% over eight days due to fears of surging interest rates and the threat of tariffs. After 2017 included only a 2.5% peak-to-trough decline in the S&P 500 and just ten days of daily moves up or down of at least 1%, we argued that investors should expect annual market declines of 10% or more, even in bull markets. Following the February decline, the S&P 500 needed 28 weeks to recover those losses by August. After a late summer rally that peaked on 9/20/18, the second 2018 market correction has persisted for thirteen weeks, and remains under way.
Over the 19-year period 2000-2018, the average annual calendar-year peak-to-trough decline in the S&P 500 was 15.9%; yet the average annual S&P 500 gain was 4.5%. Over the 10-year post-Financial Crisis period of 2009-2018, the average decline was 12.5%, while the annual price return for the index was 12.5%. Given our view that economic fundamentals remain positive despite slowing growth rates and ongoing headwinds, we believe that U.S. equities are currently undervalued. While the recent market declines are painful and create significant anxiety, we advise clients to remain focused on their long-term goals, which typically includes building a diversified portfolio across sectors and asset classes according to individual risk tolerance and investment parameters. An increase in market volatility should not negatively affect the ability of investors to reach those long-term goals.