Year End Review and 2020 Outlook: Is This a Goldilocks Stock Market?
THE END OF A HISTORIC DECADE
With 2019 and another decade in the books, many investors are wondering just how much longer this bull market can last. The past decade was the first in at least the last 170 years without a recession. The S&P 500 also did not close 20 percent below its all-time high between 2010 and 2019, which has only happened one other decade in the history of the S&P 500; and that was the 1990’s.
Some investors may remember what followed during the next 10 years. Between 2000 and 2009, the U.S. stock market experienced two separate declines of more than 45%, and two separate economic recessions. The second recession, from December 2007–June 2009, often referred to as the “The Great Recession,” lasted longer than any economic contraction since the Great Depression (1929–1933). This same decade also experienced negative returns in 4 of the 10 years, with the S&P 500 finishing lower than it began.
WHY TACTICAL NOW
Source: NBER, Bloomberg
Are we predicting for this to happen again? Certainly not. But statistically speaking, one must realize how unique the past decade has been and the probability of the decade’s performance repeating itself is very low. It may even be reasonable to prepare for the next decade to be more volatile than the last. If there is one thing we can count on, it is change.
As we start 2020, our tactical funds and portfolios have a 100% allocation to equities. While the economic environment is generally positive, there are potential headwinds in the coming year. We would like to discuss the current economic environment and, while we are currently optimistic about equities, we do have concerns.
NOT TOO HOT OR COLD BUT JUST RIGHT
Borrowing a theme from the children’s story titled “Goldilocks and the Three Bears,” a Goldilocks economy is one that is “not too hot or cold but just right.” The term, first popularized in the early 1990’s, describes an ideal state for the economy. A Goldilocks economy sustains moderate economic growth and low inflation, which often allows for market-friendly monetary policy. Sound familiar?
MODERATE ECONOMIC GROWTH
Figure 2 illustrates each of the 12 U.S. economic expansions since World War II. While the U.S. economy ended the decade with a record 126 consecutive months of economic growth, the current expansion is also the weakest on record over the past 75 years. During this time, the median annual U.S. GDP growth rate was +4.35% per year. The current expansion has grown at a meager 2.3% per year. Slow and steady growth has been the norm for over 10 years.
LONGEST BUT WEAKEST EXPANSION
LOW EMPLOYMENT AND INFLATION
The Federal Reserve has two primary mandates; maintaining full employment and stable prices. After the unemployment rate started the last decade at a 30-year high, at nearly 10%, it now stands at a 50-year low of only 3.5%. While that may seem “too hot,” other employment measures like wage growth remain tame. Remarkably, inflation has been under control for the past 25 years, and for the past 10 years, it has been under the Fed’s stated goal of two percent.
US UNEMPLOYMENT RATE
Why is two percent inflation so significant? The Federal Reserve uses adjustments in interest rates to target inflation of 2% to guarantee that the U.S. is expanding at a healthy pace. After three consecutive 0.25% interest rate cuts in 2019, Fed Chair Jerome Powell does not seem to be in a hurry to tighten monetary policy any time soon. With interest rates near their lowest level since the 1950s, Powell stated that he would prefer to let inflation rise above the central bank’s target rate before considering future interest rate hikes. “In order to move rates up, I would want to see inflation that’s persistent and that’s significant,” Powell stated in December. “A significant move up in inflation that’s also persistent before raising rates to address inflation concerns. That’s my view.”
PERSONAL CONSUMPTION EXPENDITURES CORE YOY INDEX
LOW INTEREST RATES
At the same time, 10-year U.S. Treasury yields have been declining for more than 30 years. The yield finished 2019 at 1.86%, near its lowest level in over three decades. While short-term interest rates are also near historic lows, they are still among the highest in the developed world. This dichotomy is certainly impacted by the accommodative monetary policy we are seeing around the world.
U.S. TREASURY RATE 10-YEAR CONSTANT MATURITY
CENTRAL BANK INTEREST RATES
RISING ASSET PRICES
The last characteristic of a Goldilocks economy is rising asset prices. In 2019, equities had a stellar year, with the S&P 500 capping off one of its best 10-year returns on record. While these returns sound extreme, many investors may have already forgotten the drawdown that began just prior to the fourth quarter of 2018. Viewing performance since the previous September 20, 2018 peak, returns don’t look nearly as impressive. The strongest return, the S&P 500, drops from 31% to 13%. The Russell 2000, a small-cap index, posted a negative total return over the respective time frame, failing to recapture the level it was trading at in September 2018.
ARE THERE CRACKS IN THE FOUNDATION?
The current economic factors illustrate what many would call a Goldilocks economy, but are there potential cracks in the foundation? There is definitely political uncertainty, as 2020 is a U.S. Presidential election year. It also coincides with the impeachment process for President Trump in the U.S. Senate. While the U.S.-China trade dispute may be calming down, as the Phase 1 agreement was signed in early 2020, many have expressed disappointment with the actual terms of the agreement. In addition, the recent U.S.-Iran turmoil adds to the laundry list of geopolitical concerns, including Hong Kong, North Korea, and Brexit.
If there’s one thing company leaders don’t like, it’s uncertainty. U.S. Manufacturing growth recently reached a 10-year low and business investment has been slowing. This is reflected in the most recent Deloitte CFO Signals Survey, which gauges the economic outlook of 147 chief financial officers at large North American companies. Of the respondents, 82% anticipate taking more defensive actions, like reducing discretionary spending and headcount, to stave off potential headwinds from tariff impacts, political uncertainty and geopolitical concerns.
Despite all of this, there is a big difference between the overall economy and the stock market. In fact, over shorter periods, the correlation between the economy and stocks can often be negative. For example, the stock market recorded only one negative year in the last decade (2018). However, 2018 had the largest GDP growth rate of any year in the past 10 years. The stock market does not respond directly to the economy, but rather changes in expectations of the economy and expected profits. So, even if we are in a Goldilocks economy, investors should not get complacent about the stock market.
THE MEEDER IPS
Our tactical exposure is based on a combination of risk vs. reward. The reward value of the stock market is determined by the Meeder Investment Positioning System (IPS), which ranks over 70 different factors. The IPS is has three different components; the long-term, intermediate-term, and short-term models. This reward value is then compared to market risk, our measure of expected stock market volatility, to determine the target equity allocation of our tactical funds and portfolios.
The tactical funds and portfolios started and ended Q4 2019 with a 100% allocation to equities but had an average exposure of 93% during the quarter. Market risk, our measure of expected volatility, ended the year significantly below its historical average. All else being equal, we prefer to be more invested during periods of lower volatility, which is what we are experiencing now.
Stock market trends, both in the long-term and short-term models, continue to show strong momentum. Historically, positive momentum is followed by an increase in demand. Market breadth, the measure of how many stocks are participating in the uptrend, is also positive.
We believe this bodes well for a continuation of the trend.
But the question remains, “Is everything just right?” Based on our intermediate- and long-term models, the answer is “no.” We have mild concerns about valuations, especially if earnings do not live up to double digit expectations in 2020. Leading economic indicators within our long-term model also weakened during 2019. Within the intermediate-term model, optimism has creeped into the market, which is bearish from a contrarian point of view. Looking forward, we will continue to assess the market and new information in an unbiased manner and adjust our tactical allocation in a systematic fashion.
The stock market had a stellar year in 2019 with the S&P 500 gaining a total return of 31%. Much of this was due to an increase in valuation multiples, as U.S. corporate earnings were less than impressive. While fourth-quarter reports have just begun to be released, early expectations are for a full-year 2019 earning’s growth rate of nearly zero.
U.S. EQUITY VALUATIONS
The S&P 500 (SPX) price-to-earnings (P/E) ratio compares the price of the S&P 500 to its trailing 12-month’s earnings. At the end of last year, the ratio of 21.6 was clearly above its long-term average of 16.6. Overvalued from a historical perspective, some of the strength in 2019 can be attributed to the much better outlook for earnings in 2020. Earnings are projected to grow almost 10% in 2020 on revenue growth of just over 5%.
We believe the low interest rate environment may warrant higher P/E ratios. The S&P 500’s earnings yield at the end of 2019 was 4.63%, (the inverse of the P/E ratio), easily surpassing the yield on U.S. investment-grade bonds of 3.31%. The positive difference for equities has been in place for the past several years. With no signs of immediate inflation, it appears likely that the low interest rate environment may continue over the near future. This is a positive for equities, as they may continue to appear attractive to investors over bonds.
EARNINGS YIELD RELATIVE TO INTEREST RATES
The Goldman Sachs Leading Global Current Activity Index (LCAI) combines 22 indicators that tend to lead global activity. As Figure 11 illustrates, this collection of leading indicators has worsened during the past year.
On the domestic front, the labor and housing market have been strong and consumer spending has remained solid. Yet, business investment has slowed, as companies have become more risk averse in response to political uncertainty, U.S.-China trade tensions, and a variety of other geopolitical concerns. The slowdown has been centered on manufacturing, with some concerns that it could impact other areas of the economy.
Other regions of the globe are facing even more economic trouble than the U.S. In fact, China’s industrial output reached a 17-year low in August 2019. Germany and Japan continue to struggle as well. The question remains whether there is a soft landing or recovery in site.
GOLDMAN SACHS LEADING GLOBAL CURRENT ACTIVITY INDEX
Our model contains factors that track sentiment to identify periods of optimism and pessimism, looking for potential turning points in the market. As Figure 12 illustrates, the emotions and psychology of investors tend to change with swings in the market. Historically, we have seen major market bottoms surrounded by panic and despair. When selling pressure is exhausted and prices start to move higher, we typically start to see a mix of hope and relief, as skeptical investors on the sidelines slowly buy back into the stock market. Investors turn optimistic and eventually this optimism turns into euphoria, which is often a sign of a market peak.
THE SENTIMENT CYCLE
During the past few months, individual investor sentiment has caused the intermediate-term model to worsen. The Hulbert Stock Newsletter Index reflects the average recommended stock exposure by market newsletters. The recommended exposure by this group of newsletters ended the year at 80%, which was higher than 96% of their recommendations made during the past 20 years.
This bullish sentiment was mirrored by the American Association of Individual Investors (AAII) Survey and the Investor’s Intelligence Index, both of which track the optimism and pessimism of individual investors. Equity option activity is reflecting a similar type of optimism, as our ratio between bullish calls and bearish puts was higher than 81% of the readings taken during the past 20 years.
As Warren Buffet once said, “Be fearful when others are greedy, be greedy when others are fearful.”
INDIVIDUAL INVESTOR SENTIMENT
Source: Bloomberg, Investors Intelligence, AAII, Hulbert Financial Digest
Our short-term model is comprised of primarily technical factors, focusing on both trends and momentum of equities. All 10 of our factors within the short-term model are positive. We do not believe there is one magic moving average or time frame to define a trend, so we aim to create a collection of various factors to give us a holistic view of the underlying trend and momentum.
ALL TREND & MOMENTUM FACTORS POSITIVE
Market breadth, which measures the participation of stocks within a market, is another factor that was very bullish in December. The upper blue line in Figure 15 illustrates the New York Stock Exchange Cumulative Advance/Decline (NYSE AD) line. This line represents a cumulative tally of the total number of advancing securities vs declining securities within a trend. In other words, it answers the question of whether a few large companies are pushing an index higher or there are a wide variety of industries and stocks doing well.
POSITIVE MARKET BREADTH
As you can see, we have had positive market breadth and it has been leading the market higher throughout much of 2019. This is very different than the breakdown in market breadth ahead of the fourth quarter of 2018. This type of widespread participation is a positive factor within the short-term model.
Market risk, our measure of expected volatility, decreased throughout the year and especially during the fourth quarter. Starting the quarter at 16%, this metric moved all the way down near 9% in late December.
As you can see in Figure 16, the market risk at the end of 2019 was significantly lower than it’s long-term average. This is important because, historically, there has been an increase in equity volatility ahead of major market peaks. Long, steady uptrends are surrounded with low volatility, just like we are experiencing now. This is an important reason our tactical funds and portfolios currently target a 100% exposure to equities.
Meeder’s objective is to limit participation in more severe market declines while providing the opportunity for growth during low risk markets. Utilizing a systematic approach, our investment strategy is built on probabilities, not possibilities. We believe this focus helps clients stay committed to their investment strategy and ultimately reach their investment destination.