he roaring bull market of 2019 pushed US equity markets up nearly 30% despite relatively flat earnings. As a result, the S&P 500 enters 2020 at valuation levels that have only been exceeded for an extended time period during the 1999/2000 technology bubble.
We believe that earnings growth in 2020 is likely to undershoot the current 9% growth currently expected by market analysts[1]. If we are correct, then further dramatic gains in US equity markets will require pushing market valuations into bubble territory.
The Federal Reserve’s current monetary policy is remarkably similar to Fed policies in 1998 and 1999. We believe these overly aggressive policies fueled the buying frenzy that marked the final stages of the 1990s equity market bubble.
If the Fed remains on its current expansionary course throughout 2020, and we think they will, then equity markets could start the new decade with a bubble.
The final stage of a bubble often provides the highest returns, and so we will retain our current overweight equity positioning. Our positive outlook is predicated on the Fed continuing it current policy of printing money and buying government bonds. We therefore have put in place an aggressive risk management plan that we will execute if Fed policy changes.
US equity valuations are at extremely elevated levels as measured by two popular valuation measures – trailing P/E and Schiller P/E. As shown in the chart above, the S&P 500’s current ratio of price to trailing 12 month earnings (its trailing P/E ratio) is close to 25x, a level that has only been exceeded for an extended time period during the tech bubble of 1998-2000[2].
Yale economist Robert Schiller has long advocated using average earnings over the past 10-years instead of the past 12-months. This “Schiller P/E” also shows current S&P 500 valuations to be higher than at any time other than the 1990s tech bubble, as shown in the chart below.
We do not believe that current high valuations will be validated by strong earnings growth. The earnings optimism expressed in 9% growth estimates is premised, in part, on reduced trade frictions thanks to the US/China Phase 1 agreement and a Brexit resolution.
In addition, the US, Europe, China and Japan are all providing substantial fiscal stimulus in 2020 through increased government expenditures and higher budget deficits. This fiscal stimulus is being supported in all four major economic blocs by aggressive monetary stimulus.
Despite all this support for economic growth, we believe that subdued US business investment is likely to depress overall earnings growth in the US. We do not believe that President Trump’s Phase 1 trade deal resolved any significant trade issues.
The Conference Board surveyed 740 CEOs about their plans for 2020. Art van Ark, the Conference Board’s Chief Economist, summarized CEO attitudes by saying “As long as we don’t have any guidance about where it’s going to go next, it’s very hard to make big investments.”[3] We are concerned that this headwind to US corporate investment will be exacerbated by a big pullback in energy investment and a longer than expected suspension of 737-Max production.
The fracking boom of the past decade has made the US economy highly dependent on energy investment, as we learned in 2016. The oil prices collapse in 2014 and 2015 caused the US rig count (a good proxy for energy investment) to drop from 1600 to just over 300 during the lows of 2016 (see the chart below).
This drop in energy related capital investment helped cut US economic growth in half, from close to 3.0% in 2015 to just over 1.5% in 2016. A doubling of oil prices and rig counts in 2017 and 2018 were big contributors to US economic growth over the past 3-years.
Unfortunately for economic and earnings growth in 2020, fracked oil wells have proven less profitable and less productive than originally expected. Fracked wells have also proven to run dry much faster than originally expected. Less profitability and a shorter life span are forcing both equity investors and bank lenders to reduce funding for continued energy investment. Energy investment has a large multiplier effect on overall US manufacturing, because US producers tend to have competitive advantage in the specialized equipment and materials required for fracking.
Unless current Middle East tensions push oil back toward $100, fracking investment is likely to decline in 2020 and take overall US manufacturing down with it, in our view.
US manufacturing dependence on energy is only rivaled by its dependence on Boeing airline production. The 737-Max problems have thus far not impacted overall economic growth because Boeing continued production through December. Boeing recently announced it will halt production in January. With 400 planes in inventory and uncertain future demand for a plane with a tarnished reputation, production may not restart in 2020.
The US economy enters 2020 with a full court press of fiscal and monetary stimulus. The US budget deficit is expected to increase from about $960 billion to over $1.2 trillion, fueled by big increases in defense and domestic sending. This deficit spending is being facilitated by an extraordinarily accommodative monetary policy, as the Fed responded to equity markets stress by lowering rates 0.75% in 2019 (from a range of 2.25%-2.50% to 1.50%-1.75%).
The Fed’s policy accommodation kicked into an even higher gear during the fourth quarter of 2019. In September, the bond market appeared to choke on massive bond issuance from the US government. Rates on “repo” agreements spiked to as much as 10%. Since repo agreements are the primary funding mechanism for government bond purchases, severe stress in the repo market indicated that US government deficits exceeded available reserves for bond purchases.
The Fed responded by pledging to reinvest $40 billion in maturing bonds and buying $60 billion in government bonds with newly printed money, essentially providing an additional $100 billion per month to fund continued government borrowing.
This is not the first time the Fed has lowered interest rates and aggressively printed money despite historically low unemployment. In late 1998, with unemployment close to current levels, the Fed responded to the Russian default and collapse of LTCM by lowering interest rates.
Concerned about liquidity problems in the run-up to Y2K, the Fed also aggressively printed money throughout 1999. We believe that this aggressive monetary accommodation in a relatively strong economic environment helped fuel the equity market bubble of the late 1990s. With similar economic and monetary conditions currently in place, we could see US equity markets revisit the bubble level valuations seen during the last stages of the 1990s bull market.
US equity markets are expensive and earnings growth could disappoint. However, we believe equity markets can keep moving higher so long as the Fed keeps rates low and primes financial markets with $100 billion in additional liquidity each month. This overly accommodative policy could inflate another equity bubble.
The Fed has signaled that it will not raise rates until inflation rises substantially above its 2.0% target, but it has only committed to continue printing money until the end of the first quarter. When the Fed stops printing money, we fear the bond market could once again choke on the combined capital requirements of a growing US economy and a bloated US budget deficit.
President Trump is likely to put unrelenting pressure on the Fed to keep the money flowing and the markets rolling. If Fed Chairman Powell continues to bow to this political pressure, then the money printing should continue until the November election and equity markets continue to climb. If we are wrong and the Fed shuts off the printing presses at the end of Q1, then we will aggressively reduce our equity weighting.
