Apart from a continuing rally on the back of unchanged fundamentals, there is little new to report on equity markets. The S&P 500 is up another 100 points to 3,110 points, the interest-rate environment is much the same as last month and the end of the Q3 results season proved uninspiring. Our year-end objective is now at 2,846 points, pretty much in line with where it was a month ago (2,834 points) and implying a 9% overvaluation that we would struggle to justify with reference to interest rates or profits. There is just one of our valuation model’s parameters that we have not tweaked: the risk premium, which we have kept at 3% above the yield on government debt. But given that the yield on the Treasury long bond has fallen in stages from over 10% 40 years ago to 2.26% today, investors may well have eased up on the risk premium they require from equities. If we cut it to 2%, our year-end objective rises to 3,654 points. Our own preference is to avoid tinkering with the model in this way, however, and we are maintaining an equity market allocation at 35% (although it has climbed to 37% because of the rally) compared with a benchmark allocation of 40%.
The market is assuming that an agreement between the USA and China over trade is a done deal, but the negotiations are dragging on. At the end of the day, high-tech America will send the Chinese a few million pigs and shedloads of soybeans amid hopes that they will obtain better protection of intellectual property in return. The Chinese want tariffs to be removed, but US negotiators need leverage to ensure a deal is respected. Traders are taking it for granted that the yuan will stay firm and lobbyists back in America are pushing Donald Trump towards an agreement on the grounds that he will not want to disappoint investors in an election year. It could all add up to a poor agreement.
US GDP growth has slowed on trend from around 5% per year in the 1960s to 2% in the present decade, which is now accepted as its normalised rate. Forecasters expect 1.8% in 2020. Following acceleration in the 1990s and up until 2006, and particularly after the financial crisis, the world growth rate has eased from 3.5% to 2.7% in local currency terms. Increases in corporate profits over the period are all the more remarkable for the fact that margins are at historical highs, thanks to IT. US profits have been growing 1.3% faster on trend than GDP, although recent tax reform has had a part to play in that too. Repeating that adjustment would be difficult. The US economy is currently enjoying its longest-ever period of uninterrupted annual growth, but it is hard to see recession being held off forever and that will affect the earnings CAGR in our valuation model. We are currently using a CAGR of 2.1%, rather than the 3.3% that would justify equity prices. Note that earnings estimates for 2019 are now falling, and projections for 2020 are being revised lower. Q3 results announcements included significant revisions for Q4 and onwards from the corporate side, especially among Russell 2000 small caps dependent on domestic demand. Recent declines in investment and the uncertainty inherent in an election year will both weigh on profits.
Low interest rates are still the only good reason why world equity markets are up 24% – and Wall Street up 26% – this year. Liquidity injections by the Federal Reserve have only fuelled the rally. The most recent PMIs are positive and offer some hope of a rebound in growth.
A survey of market strategists gives us an average expectation of 3,272 points for the S&P 500 next year, with Morgan Stanley and UBS at 3,000 points. Our own assessment is 2,950 points. Our European market valuation is close to current trading levels.
