foxex: A Diverging Path in 2019

Focus on the Price

Monday, December 24, 2018

1. Earnings yields continue to look better

2. The dollar is one of 2019's biggest risks

3. Outlook for 2019 depends on external issues

Major Moves

The decline in the market, or least the S&P 500, at the end of the year was typical of what we expect at the beginning of a recession or other economic downturn. Small caps were off -25% last week since their peaks in August. A decline of -20% or more is technically considered a bear market which is something we haven't experienced since 2011.

What is different about 2018, compared to most significant downturns, is that economic fundamentals have been very positive all year. Previous instances where the market declined while earnings performance was still very positive were almost always driven by externalities such as: government budget fights, debt ceilings, or tariff wars.

As I have mentioned in prior issues of the Chart Advisor newsletter, the 2010 and 2011 downturns were driven by non-valuation issues like 2010's flash crash, and the fiscal cliff, which has some parallels to events this year. Investors are justifiably concerned that President Trump's tariff war with China will not only affect the Chinese economy, but will indirectly impact commodity prices and industrial demand here in the US as well.

I still believe that, if for no other reason than political expediency, there is a high probability that the trade war will be put on hold or ended in the short term. If I'm right about that, then I think the market fundamentals are very supportive of higher prices.

The S&P 500
In the following chart, you can see the S&P 500's price (gold line) compared its quarterly earnings-per-share (blue line). You'll notice, that on a year-over-year basis, growth in earnings has been positive since the end of 2015. Declines in earnings growth rates are predictably accompanied by volatility in the market which is what has made 2018 so unusual.

I think it is highly likely that part of the reason investors have been so willing to sell is that although growth rates were positive, the earnings yield on the S&P 500 reached an extreme low in the beginning of 2018 which made the risk/reward iffy for more buyers. You can think of the earnings yield as earnings-per-share/index value, which also happens to be the inverse of the P/E ratio. In the chart, the red line is the earnings yield which was at approximately 4.5% at the end of the third quarter this year. This was a little bit of an improvement compared to the first quarter but still very low. The earnings yield hasn't been this low since the start of the recovery.

A low earnings yield (or a high P/E ratio) can be justified if interest rates are very low. However, a series of eight rate hikes in a row has weakened that argument. Stocks must compensate investors for the risk that they are taking above the return they could get by buying US Treasury bonds. Therefore, if investors can make more from short-term deposits or Treasury bonds, stock values have to come down in order to provide a justifiable return for new buyers.

You will notice that we don't know what fourth-quarter earnings look like yet; however, most estimates show year-over-year growth in the 20% range, that should further improve the earnings yield considerably. So although the yield will still be very low, the S&P 500 has a lot more overhead clearance than it did in 2017 or 2016 from a valuation perspective.

Risk Indicator: US Dollar

One of the challenges facing the market in the new year that hasn't received a lot of attention in 2018 is the value of the US dollar. Normally, rising tariffs and short-term interest rates (both of which the US economy experienced in 2018) will increase the value of the domestic currency. This makes imported products cheaper, which dampens any possible positive tariff effects, and it makes US exports more expensive. That's bad.

Another issue is that profits earned in a foreign currency by US multinationals are then translated into a stronger dollar which means that those profits are lower in dollar terms. For example, imagine a year ago the dollar and the euro were at parity and your company earned 1 euro in profits which was translated back to your US shareholders as 1 dollar in profits. If the dollar appreciates against the euro to exchange rate of $.75 over the next year, then the annual profit of 1 euro is translated back as $0.75.

A stronger dollar hurts the trade balance and reduces multinational profits which was a big problem for the S&P 500 back in 2015. As you can see in the following chart, the dollar is back to those prior levels. This means that companies trying to profit in Asia and Europe (where economic growth has been much worse in 2018) are facing additional headwinds from a rising dollar.

The following chart of the dollar index is a measure of the dollar's value on a trade-weighted basis and, although its value is extremely elevated, we may see some resistance near its prior highs. Assuming the tariff wars are resolved in some fashion, the dollar could fall quickly, which would lead to a much less dire situation than the end of 2018.

Bottom line: 2019 Doesn't have to be a bad year

In many ways, the market is at a make or break point. On the one hand, valuations have come down a lot and economic growth remained stable in the US. If the negative externalities I have discussed in this issue are resolved, 2019 could look a lot more like 2017 or 2016. A positive outcome is therefore dependent on the resolution to the trade situation and a weaker dollar. The alternative is that economic fundamentals continue to deteriorate in Asia and Europe, trade continues to slow, and investors start pricing in a recession. These two possible outcomes are on extreme ends of the spectrum, but–at this stage in the business cycle–pivots like that aren't uncommon.