In our 21 December edition we argued that an S&P 500 at 2,426 points was already a low that priced in an awful lot of bad news. When the index dipped to 2,351 points on 24 December we took it as a buying opportunity, just as we had previously suggested. The market has since rallied 13% to 2,665 points, and according to our calculations fair value under a probable scenario of a conventional economic slowdown is 2,641 points. In the case of a moderate recession it would be 2,391 points, suggesting that the market is unlikely to revisit its 24 December low.
The parameters underpinning our valuation are earnings per share growth stabilising at 2.1% in 2019, compared with a consensus estimate of 5.2%, and a rebound to 8% in 2020 compared to a consensus view of 11.1%. As we expected, the US 30-year rate has stabilised at 3%. Our 8-year CAGR is 3.4%, which may look low but takes account of a probably decline in profit margins from their current historical highs. Given the persistently risky trading environment – the VIX is still high – we are leaving our recommendation for investors to underweight their benchmarks unchanged. That said, investors should not hesitate to re-enter the market if irrational declines present fresh opportunities. By happy coincidence, we picked both the market’s high on 28 September and its (for the time being) low in December. But we are by no means immune to an exogenous shock that undermines all our valuations.
Wall Street’s rebound followed more conciliatory commentary from the Fed, with Chairman Powell explaining that “we are listening sensitively to the message that markets are sending about downside risks”. In a sense the markets are dictating the way ahead on monetary policy: the 2-year Treasury yield has eased from a recent high at 3% to as low as 2.38%. The current 2.63% points to one hike in 2019 and another next year. The contraction of the Fed’s balance sheet is also being approached more cautiously. In the meantime, China and the USA really have to reach a compromise because Chinese growth is slowing and American corporate profits are starting to suffer, starting with Apple. Donald Trump needs a firm stock market for his re-election campaign.
World GDP growth is still slowing, and forecasts are down for all regions. The overall consensus view is 3.1% in 2019, compared with 3.4% in 2018. Lower oil prices may help to stabilise these numbers. The car industry is showing tangible signs of weaker activity, with sales down sharply in China and Europe since last summer. Economic indicators such as US consumer confidence and US and eurozone PMIs have faltered, and on top of all that the great Brexit unknown could create a shock. US corporate results highlight downward revisions to profits estimates, notably in the energy and IT sectors. American EPS growth is expected to be zero in Q1 and in low single digits in Q2 and Q3.
World equity markets are up 6.1% so far this year, almost making up for the 6.9% drop recorded last year. Small and mid caps have rebounded 8.6% after their severe correction in 2018.
Eurozone earnings estimates are still being revised down for 2018, and could end up close to zero growth. Forecasts for 2019 are also subject to downward revisions. Long rates are still incredibly low but the economy is simply not reacting to them. Similarly, eurozone equities are cheap but investors remain unimpressed.