Bank of America quantitative strategist Savita Subramanian is bullish on equity markets for the next decade but this optimism comes with a warning that investors should brace for a difficult start to 2020.
Equity markets are in a relatively precarious position, and that doesn’t even take into account the risks associated with the sharp escalation in tensions between the United States and Iran.
The equity market rallies of 2019 were characterized by a distinct lack of earnings growth – an unsustainable trend. In the most recent profit reporting season, the S&P/TSX Composite Index profits were only 2.9 per cent above the previous year and the S&P 500 saw a year-over-year earnings decline of 1 per cent.
Equity markets’ strong finish to 2019 reflects optimism that the growth outlook is set to improve. In Ms. Subramanian’s words, investors “pulled forward” the expected benefits of a profit recovery into stock prices during 2019.
Stocks prices: Ahead of the fundamentals
Year-over-year percentage change
MSCI World Index (left scale)
JPMorgan Global Manufacturing PMI Index (right scale)
30%
8%
25
6
20
4
15
2
10
0
5
-2
0
-4
-5
-6
-10
-15
-8
‘13
‘14
‘15
‘16
‘17
‘18
‘19
the globe and mail,
source: scott barlow; bloomberg
Stocks prices: Ahead of the fundamentals
Year-over-year percentage change
MSCI World Index (left scale)
JPMorgan Global Manufacturing PMI Index (right scale)
30%
8%
25
6
20
4
15
2
10
0
5
-2
0
-4
-5
-6
-10
-15
-8
2013
2014
2015
2016
2017
2018
2019
the globe and mail, source: scott barlow; bloomberg
Stocks prices: Ahead of the fundamentals
Year-over-year percentage change
MSCI World Index (left scale)
JPMorgan Global Manufacturing PMI Index (right scale)
30%
8%
25
6
20
4
15
2
10
0
5
-2
0
-4
-5
-6
-10
-15
-8
2013
2014
2015
2016
2017
2018
2019
the globe and mail, source: scott barlow; bloomberg
Where U.S. profits are concerned, however, there are few signs of a turnaround, she points out. Bank of America reports that the earnings revision ratio – the number of positive changes to corporate earnings forecasts divided by cuts – comes in below one, at 0.68, signalling more downgrades than upgrades.
In addition, Standard & Poor’s is projecting another year-over-year decline in profits (minus 0.3 per cent) for the upcoming U.S. earnings season. A CNBC report noted that, of the 15 major companies reporting fiscal year-end earnings in November, including FedEx Corp., Oracle Corp., Nike Inc. and General Mills Inc., analysts cut the targets on 10 of them after seeing the results.
But the clearest sign that stock prices are ahead of fundamentals comes from global economic data. The accompanying chart compares the annual change in the MSCI World Index equity benchmark and the JPMorgan Global Manufacturing PMI (purchasing managers index). The latter, a composite index, compiles national surveys of prominent industrial executives who answer questions regarding business activity, hiring and new orders for goods.
Between 2012 and the end of 2018, the annual change in global equity prices closely followed the annual growth in manufacturing activity. In 2019, the relationship broke down, with equity prices surging well ahead of sluggish data.
The trend of disappointing growth data continued on Friday, although it’s not included in the chart. The ISM survey of U.S. manufacturing came in at 47.2 when 49 was expected. A reading below 50 indicates a contraction in activity.
The divergence on the chart should eventually close in 2020. An optimistic take would be that the expected resurgence in global growth will bring the blue line up toward the growth path of equity prices. If, however, the recovery does not materialize, investors can expect market weakness as stock prices fall to reflect the slower-than-expected expansion.
A recovery in corporate profits and economic growth is already built in to market prices, at least in part. This implies that an improvement in earnings or economic data will not push equities much higher. It also suggests that disappointing data are likely to result in significant selling pressure as expectations for good news is already priced in.
Ms. Subramanian’s analysis of current stock valuations leads to a forecast of 5 per cent annual growth for U.S. stocks in the next 10 years which, combined with a dividend yield of about 2 per cent, will generate healthy returns. Her work, however, implies that 2020 will represent a “difficult start” to the decade.
Scott Barlow