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2019 Annual Update and Outlook

 

Revisiting our 2018 prediction of a 6% return, we clearly missed the mark. However, just as everyone is ready to turn negative on the markets and economy, it is just about the time to get positive. At the outset of 2018, most professionals were expecting GDP growth of 2.5% or lower, even with the tax cuts. It turns out that growth was closer to 3% for the year and earnings followed suit, rising by nearly 20%.

There is quite a bit of debate heading into 2019 surrounding earnings and the economy. Over time, the returns in the S&P 500 have followed the earnings of the stocks comprising the index. This can be seen in the chart below. The clear exception is the extreme drop in earnings and corresponding extreme growth in 2008/2009. The S&P 500 earnings in 2018 were approximately $162. Current expectations for 2019 are just over $170 per share or about a 4-5% growth rate. Normally this would equate to a muted market return. However, in 2018 when earnings grew at greater than 20%, it was highly unusual for the market to turn in a negative return.

 

 

The negative return could be attributed to the exceptional return we had in 2017. However, with earnings growth in 2017 of 16.2%, the 21% return on the S&P 500 seemed to make sense. So why would a 20% earnings growth in 2018 give us a negative return on the S&P 500? Simply put, it had nothing to do with the earnings we had, but the fear of the Fed and Trade policy creating negative earnings growth in 2019.

As of the end of 2018, the Fed has increased rates 9 times since it began the current cycle. A chart we posted in 2017 alluded to the fact the Fed usually goes too far after the 5th hike. This time not only has the Fed increased interest rates, but they are starting to reduce their balance sheet by not continuing to buy debt obligations in the open market, as they did under Quantitative Easing (QE). They are now taking those monies and reducing the balance sheet instead of maintaining the assets added during QE in the Great Recession. This is in effect tightening, even if they did not raise rates. Markets are absorbing two policy changes instead of the normal one policy change.

 

 

If we see earnings growth in 2019 become negative, we would highly doubt the S&P 500 turns in a positive year. However, we think the market, with some help from higher oil prices in the mid $50's, will grow back to a normal Price to Earnings Ratio near 16 (the 25-year average). This would put the S&P 500 back at 2750 or nearly 12% higher than the price as of January 3, 2019.

To get to this level, we will see some increased volatility in the market. We also see the Fed become a bit more accommodative to the markets. They will need to either dial back their rhetoric on raising rates and/or reducing their balance sheet. One of them will have to give. The other bet on the markets has to do with China relations. We need a trade policy that is fair to both sides. If we create the "ultimate" deal that is only advantageous to the US, China loses and so will their mass of US goods buyers. The optimal trade deal would phase in over the next 5-10 years, but it is unlikely our President has an appetite for this characteristic. We expect both leaders will try to craft a deal which would show a win for both sides instantly.

We caution you to not look at the negative points of this market and instead focus on the positive attributes. The long-term positive momentum of lower taxes, higher cash flow, a healthy consumer, and a government without one party in power are all direct positives on the market.

If you missed our latest slide show you can view it on YouTube.  I will reiterate a point of emphasis of why this market will ultimately move higher. Just as our post at the start of 2018 showed the market as overbought (see 2018 outlook), we are now seeing just the opposite with the market being oversold. Each time the market was oversold over the last 15 years, it was a good time to buy. It also does not mean the market is immune from going down a bit further (the oversold indicator was early in 2008, but ultimately right and would have returned nearly 100% to today's levels). In fact, I would expect the market to retest the lows of December before moving higher. From this point, a double-digit return in the market is not out of question. If the market corrects a bit further, the returns from the lows should be over 15%.

 

 

Going back to our earnings estimates for 2019, if we see a rise in earnings of 5% coupled with our 20% in 2018, this would set the stage for a double digit return in 2019 (including dividends which will account for about 2% of the return). As we stated, there are a few factors that will likely come into play but remember, all politicians want to be re-elected and liked by the people, even if they do not always act appropriately at all times.

We do want to show one more chart which we have shown in the past. It is the relationship of Value to Growth Stocks. We continue to believe Value stocks are undervalued and have been for some time as the masses of people have poured money into index funds supporting growth stocks and ETFs like QQQ. We are starting to see a slight reversal of this as many of the FANG stocks have fallen out of favor recently and those who owned them have started to sell causing them to drop more than 25%. The last time we saw Value stocks this low when compared to Growth stocks was just prior to 2001. Many of these solid companies are currently paying dividends well beyond their 10 year average dividend yield. However, we expect these "cash cows" to gain some respect as the volatility of the market continues its jittery pace. Volatility has been fairly muted as a whole since 2008. As rates rise and volatility rises, we believe Value will shine again.

 

 

Looking Ahead:

The market will continue to look forward. Even if the Fed overreacts and the market corrects further than we anticipate, the Fed will have to step in and halt their balance sheet reduction and either maintain rates or lower them. Although at this point earnings may be less than 2018, the outlook would be higher and therefore the markets would move higher.

Our outlook is still positive even with a short-term correction in process for the markets. We expect the market to return near double digits in 2019 with some help from Washington. In addition, as we stated for 2018, we see a higher interest rate environment and will continue to stay on the shorter-end of the curve with our debt selections. We will keep you up to date if expectations for the market or politics impacting the market change. For now, stay invested and look for opportunities to continue investing. Stocks appear to be oversold and represent a good long-term buying opportunity.

Regards,

The Newton Wealth Management Team
 

W. Edward Newton, Jr. CFPģ

NewtonWealthManagement
13850 Ballantyne Corporate Place, Suite 500
Charlotte, NC 28277-2830
704.552.8689
Email: ed@newtonwealthmanagement.com
Website: http://newtonwealthmanagement.com/

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