Markets defy profit fundamentals, putting equity valuations at risk
So far in 2020, investors have been focused on the positives. The trade truce with China was a “done deal,” global growth is expected to re-accelerate, and monetary policy is accommodative. In other words, equity valuations have been discounting a perfect alignment of political stability, an economic rebound, and monetary stimulus.
Is that reasonable? We are concerned that the answer is “no” for three reasons:
Reason #1: The earnings story for 2020 is not convincing.
On average, earnings should grow at about the same rate as nominal GDP growth, plus any adjustments for share buybacks.
Analyst estimates for earnings growth in 2020 currently exceed 10%. That means even if you take economic forecasts at face value, earnings estimates outpace the fundamentals by at least 5%. And while it is not unusual for earnings estimates to be revised down throughout the year, markets can only defy fundamentals for so long.
Reason #2: Companies have very little buffer against risk.
Revisions to national accounts data throughout 2019 revealed weaker corporate profits and lower profit margins than previously understood. Admittedly, interest rates are lower, alleviating some pressure, but we doubt that reduced interest cost itself is enough to boost profit margins in the face of higher labor costs and structural shifts. The resulting thin margins — or less profit for the same amount of revenue — reduce businesses’ willingness to hire and invest. This makes the economy even more sensitive to risk.
Declines in profit margins precede economic downturns
Considering these downward revisions and the one-off impact of recent tax cuts, profit margins have been losing steam since 2014. What’s more, free cash flow per share peaked in early 2018 and has since declined, indicating that the current expansion is in its later stages. We do not expect this trend to reverse.
Reason #3: Economic growth expectations are rosy.
In 2019, U.S. GDP growth was about 2.0%, which was very near its expected trend level. Expectations for 2020 have been revised up. So, where would that additional growth come from?
While the labor market is strong, wage growth has lagged, reducing any potential acceleration in consumer spending. Also, major changes to government spending are unlikely in an election year. And, even though trade volumes are considered to be a small portion of the overall U.S. economic picture, they are expected to be volatile.
That leaves business investment to make up the difference. In light of the profit dynamic described above, a surge in capital expenditures (CAPEX) looks unlikely in 2020.
Business planning risks make an uptick in economic activity even less certain. The trade war with China may be calming for the moment, but tariffs are still in place and the damage to business plans and supply chains has already been done. A renewed focus on trade with Europe, with auto manufacturing at the center, cannot be ruled out. CEO confidence deteriorated throughout 2019 even as news of a trade truce hit the headlines. And, it is an election year.
The result? Equity valuations are at risk.
We believe equity markets are defying profit fundamentals. While valuations are not yet at extreme levels – and we will write about that in an upcoming post – they do reflect complacency. It is difficult to time a market ceiling, but these factors demonstrate to us that risks are elevated.
For most investors, capital preservation is more important than the last bit of potential upside. That is why, on a structural basis, we have been moving our portfolios to a more defensive posture. We are gradually moving the core of our portfolio to yield-focused equities, higher-quality and shorter-duration credit, and diversified sources of income such as real estate and municipal bonds.
That is not to say there won’t be opportunity in 2020. We expect volatility to remain the norm, which creates opportunities particularly when liquidity and sentiment dynamics drive markets. To create flexibility and take advantage of these opportunities, we are taking some proceeds of sales at market highs to build flexibility for short-term cyclical upside.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
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