At first glance, U.S. equities seem to be riding a bullish wave. The S&P 500 is up more than 20% in 2019, and the steady stream of IPOs for high-profile “unicorns" throughout the year suggested there was still appetite for growth-story stocks.
The consensus outlook estimates 11% earnings growth next year, vs. flat growth for this year, suggesting that the market has room to run.
In actuality, stocks are sitting under a pall of pessimism, with the market little higher than it was in September, 2018. What upside we’ve seen has been fueled by corporations buying back their own stock and investors bidding up so-called “safety” stocks.
Individual investors, for their part, largely haven’t benefited. Between early December, 2018, and mid-August, 2019, equity mutual funds and exchange traded funds saw $230 billion in net redemptions. As a percentage of total assets, the 52-week outflow is the most we've seen since the bottom of the market in 2002. Meanwhile, investors have poured more than $476 billion into money market funds so far this year.1
This is a classic case of recency bias, where investors’ decisions are based on what's behind them, rather than what's ahead. Although this bearish sentiment has taken hold for many investors—and has even been the topic of some debate here at Morgan Stanley—my team and I believe that this outlook misses some significant positive factors for 2020: potential for improving earnings against relatively weak year-over-year comparisons and an incumbent president intent on boosting the economy, as election day 2020 approaches.
Here are some key points for investors to keep top of mind, as we hit the final stretch of 2019, and into year ahead.
The Power of an Election Year
Historically, the re-election of an incumbent U.S. president hinges largely on the economy. Over the past century, an incumbent was re-elected in all cases where there wasn't a recession in the previous two years; in only one case—Calvin Coolidge—did an incumbent win despite a recession.
The Presidential cycle has historically had an impact on markets
(No recession 2 years before election vs. recession 2 years before election)
| Recession? | President (Year) | Reelection? |
|---|---|---|
| NO | Obama (2012) | YES |
| NO | Bush 43 (2004) | YES |
| NO | Clinton (1996) | YES |
| NO | Reagan (1984) | YES |
| NO | Nixon (1972) | YES |
| NO | Johnson (1964) | YES |
| NO | Eisenhower (1956) | YES |
| NO | Truman (1948) | YES |
| NO | FDR (1944) | YES |
| NO | FDR (1940) | YES |
| NO | FDR (1936) | YES |
| NO | Wilson (1916) | YES |
| YES | Bush 41 (1992) | NO |
| YES | Carter (1980) | NO |
| YES | Ford (1976) | NO |
| YES | Hoover (1932) | NO |
| YES | Coolidge (1924) | YES |
| YES | Taft (1912) | NO |
Yet voters have short-term memories. The key isn't how the economy performs during this quarter, but how it's faring this time next year. The current administration knows this, which could be why the administration is proceeding deliberately with China trade negotiations. A lack of resolution on trade near-term could also compel the Federal Reserve to continue cutting interest rates. A China trade deal alongside lower interest rates and the promise of an infrastructure bill could mean an economic shot-in-the-arm for the U.S. in 2020.
The upshot: Our opinion is that President Trump will want the economy to be running hot heading into the polls next year. While that reduces the odds of an economic recession in 2020, it increases the risk of a pullback in 2021.
Earnings Are Set to Reaccelerate
As we've noted throughout this year, corporate earnings growth will likely be flat or contract in 2019, not because they are abysmal, but because of the comparison with exceptional growth in 2018. The market has known this, which is why stocks flirted with bear market territory late last year.
Remember, the market is a forward predictor. It rewards future positive rates of change and penalizes negative rates of change. As of early September, the consensus outlook estimates 11% earnings growth next year, vs. flat growth for this year, suggesting that the market has room to run.
I should note that my colleagues in the firm's Global Investment Committee have nuanced views on how an earnings recession could spiral into an economic recession in 2020; but, in my view, an earnings recession doesn’t always mean an economic recession. Again, this has been particularly true during an election year with an incumbent president.
The upshot: Relatively flat earnings growth in 2019 essentially lowers the bar for better comparables in 2020.
We believe a 2019 earnings recession is a possibility followed by a reacceleration in earnings
(Quarter over quarter Real U.S. Earnings Growth, Q1 2014-Present)
Sideways Markets Don't Last Forever
As mentioned earlier, the market has effectively moved sideways since this time last year. What's more, this isn't against a backdrop of investor exuberance. On the contrary, investors have yanked money out of equity funds and are hoarding cash. By many measures, bearish sentiment is the highest it's been since the height of the financial crisis.
Historically, this story doesn't end with a market crash, but a rally. On seven occasions since 1900, the market has been flat for 350 or more trading days, and in all cases, the market was up six months later.
The upshot: Markets need to boom before they bust. The longer a market trades sideways, the higher the likelihood that it breaks to the upside.
After extended periods of consolidation, the market has historically broken to the upside
(S&P 500, March 9, 2009-August 22, 2019)
Investors Should Take a Measured Approach
Several factors suggest that the market will be higher a year from now than it is today, but we aren't prescribing that investors wait for a pullback and jump back in feet first.
As is the case in virtually every market environment, we believe dollar-cost averaging* may make a great deal of sense today. Stylistically, growth stocks still look expensive relative to value, but they are not as expensive as they were at the peak in 2000. In fact, if there is any bubble today, it's in defensive stocks, such as utilities and consumer staples. Investors are paying very high multiples for relative “safety” and nothing for cyclicality.
The upshot: Investors may want to avoid extremes, both in terms of timing and allocation.
Adapted from the recent webcast “2019 Equity Market Update: Isn’t the Equity Market a Forward Predictor?" For more information, ask your Morgan Stanley representative or visit Morgan Stanley Investment Management. Plus, more Ideas from Morgan Stanley's thought leaders.
Risk Considerations
*Dollar cost averaging does not ensure a profit or guarantee against loss in declining markets. For the strategy to be effective, you must continue to purchase shares both in market ups and market downs. In addition, if the market gains, you may miss out on the potential gains.
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. In general, equities securities’ values also fluctuate in response to activities specific to a company. Stocks of small-and medium-capitalization companies entail special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. Investments in foreign markets entail special risks such as currency, political, economic, market and liquidity risks. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility.
