US equities have clawed back the losses they suffered during the correction late last year, and at 2,940 points at last Friday’s close the S&P 500 was ahead of its previous peak in September 2018. This rebound stems from the Federal Reserve’s U-turn on monetary policy in favour of renewed accommodation, together with an outbreak of peace in Donald Trump’s trade war against China. The 30-year US Treasury yield has eased from a high at 3.48% to a recent low of 2.83% over the past seven months; although our own market valuation has been adjusted upwards as a result, prices have risen by even more despite the outlook of anaemic profits this year. Our latest valuation for the S&P 500 is 2,690 points, implying a market that is some 9% overvalued. We believe that part of the rally was technical: traditional investors have made billion in net withdrawals from the market so far this year, but against that companies have been buying back their own shares at the rate of 0 billion every three months, boosting both their share prices and earnings per share. For example, Apple is expected to post a 23% drop in profits in Q1 but its EPS will fall just 12%. World markets have followed Wall Street; the MSCI World is up 17% so far this year and the S&P 500 18.2%. IT stocks have surged 27% despite virtually unchanged profits. In fact, the sector’s share prices have risen 5.3 times over in the past decade, compared with 4 times over for their market index. And who knows how far the digital economy’s outperformance can last?
Profits are running well behind share prices. Consensus analysts are banking on an average 1.8% increase in EPS this year, despite share buybacks at a rate equivalent to 3.5% of capital. Q1 results will be down 2% from a year ago, including a 32% drop in the energy sector. IT sector profits will be down 5%. The financial, healthcare, industrial and discretionary consumer sectors will all be up slightly. According to the guidance already out there, Q2 will see another drop in earnings. The 2019 PER for the S&P 500 is 17.7, and if we believe forecasts of an 11.4% rebound in profits next year it would be 15.5 in 2020. Our top-down calculations give us 9% for 2020 and 7% for 2021, assuming that no recession gets in the way. Our caution on profits reflects the slide in world GDP growth forecasts for this year to 2.9%, down from 3.3% in 2018. Notwithstanding good Q1 figures on activity, consensus and Fed forecasts for the US economy are also cautious, at 2.3% in 2019 and 1.8% in 2020. The 3.2% annualised gain in Q1 featured a sharp rise in stockbuilding that masked very sluggish consumption. The US yield curve has steepened slightly over the past month, and the 30-year yield that underpins our model has risen from 2.87% to 2.95%. All in all, our hypotheses give us an instantaneous valuation for the S&P 500 of 2,690 points and a year-end objective of 2,794 points. Our CAGR is 3.4%, which is below the potential growth rate because the model integrates a high probability of recession in the coming 8 years. In the event that materialises, the market would correct 18% initially but stabilise at -10%. We have been underweight the market for some time now, apart from a buying phase in late 2018, and that turned out to have been wrong. Our philosophy of sound management consists of maintaining exposure to equities at all times, but with marginal variations around the investor’s benchmark. Right now, for example, we are 34% exposed against a benchmark weight of 40%. Current price levels are encouraging us to stay underweight, with a view to buying upon any marked correction.
The European market is virtually at our objectives and can be seen as fair value. Incredibly low interest rates work in its favour but mediocre structural profitability among European companies works the other way.
