2019 First Quarter Review and Outlook

by | Apr 12, 2019 | Quarterly Reviews

The first quarter of 2019 has started out well with the equity markets rebounding from their 2018 loss. For the first quarter the S&P 500 Index returned 13.65%. The strong return was powered by a price to earnings (P/E) multiple expansion. The P/E ratio started 2019 at 17.89 and ended the first quarter at 21.41. Given our expectations for lower economic growth and earnings growth in 2019 versus 2018; we are not anticipating further P/E expansion for the year. We do not recommend increasing equity exposure for most clients. At the start of the year the market was worried about three major issues:

  • Would the Federal Reserve continue to raise interest rates in 2019?
  • Would President Trump be impeached because of the Mueller report?
  • Would China and the United States reach a trade agreement?

One of the reasons the P/E multiple went up in the first quarter was that the Federal Reserve made it clear that they were going to pause in raising interest rates for 2019. The lower interest rates helped drive strong equity returns in the first quarter. Investors, both individual and institutional must make asset allocation decisions based on future expected returns. Currently, the 10-year government bond has a yield at 2.41%. Most investors would expect the S&P 500 to provide a return better than 2.41% a year over the next 10 years. Another unknown variable was removed with the release of the Mueller report. The market has concluded that the Mueller report will not lead to the impeachment of President Trump.

The strength of the S&P 500 Index continues to be powered by growth stocks. The S&P 500 Growth Index returned 14.95% for the first quarter compared to the S&P 500 Value Index which returned 12.19%. Most equity asset classes showed strong returns, the S&P Mid-Cap Index returned 14.49% for the first quarter. The S&P Small Cap Index returned 11.61% for the first quarter. US Equities continue to outperform the rest of the world. International Equities, as measured by the MSCI EAFE Index returned 9.96% for the first quarter. Emerging markets, as measured by the MSCI Emerging Markets Index returned 9.70% for the first quarter. Given the lower economic growth expectations of Europe and the unknown consequences of Brexit, we continue to recommend overweighting US Equities versus International Equities. We continue to worry about China and recommend underweighting exposure to Emerging Markets.

If you were looking for a sign of irrational exuberance, it may come in the Initial Public Offering (IPO) market. This year should see the IPO of several high-profile companies that are losing money. Lyft just went public with a valuation over $20 billion despite losing over $900 million in 2018. Pinterest, with losses of $63 million in 2018, and Uber, with losses of $1.8 billion in 2018, are both scheduled to go public this year. Of course, every investor hopes a money losing company turns in to Amazon which has provided a return of over 1000 times for IPO investors despite losing money for several years as a public company. In 2018, 80% of all companies that went public were unprofitable. An Amazon type return seems doubtful for most of these money losing companies. The major question is what companies will follow the path of Webvan and Pets.com. Two money losing companies that went public in the dot com bubble and declared bankruptcy a few years later.

The stock market reacted negatively to the December rate hike and was worried the Federal Reserve would stay on the declared path of raising rates .5% in 2019 and possibly causing a recession. In the first quarter, the Federal Reserve signaled no rate hikes this year and that it will taper its balance-sheet roll off. The Federal Reserve moved closer to the market’s perception of a slowing economy. The Federal Reserve is still forecasting one rate hike of .25% in 2020. The market is forecasting a 61% chance of a rate cut by the end of 2019.

The prospect of fewer rate hikes has led to lower interest rates in the United States. The 10-year government bond started the year with a yield of 2.66% and ended the first quarter at 2.41%. The drop in yields helped the Barclays US Aggregate Bond Index return 2.94% for the first quarter. The issue for investors is that if you currently purchase a 10-year government bond the yield is only 2.41%. Investors are comparing the return of the 10-year government bond to the S&P 500 which currently yields 1.79%. Investing in the S&P 500 Index has the potential to provide greater returns with increased earnings and dividend payments. Even if the S&P 500 provides lower than historic returns, most investors expect it to outperform the 10-year government bond over the next ten years.

The risk of investing in equities is that the S&P 500 has dropped close to 50% twice in the last twenty years. In the beginning of 2008, the 10-year government bond yielded 3.91% and you could have made the same argument that the S&P 500 should provide a better return than the government bond. Of course, in 2008 the S&P 500 dropped 36.85%. However, the annual return for the next ten years (including 2008) was 8.49%. We still recommend a fixed income exposure to lower the volatility of the overall portfolio. We recommend that investors match upcoming cash flow needs, including required minimum distributions, with high quality bonds that mature at the time of the cash flow needs. This strategy will protect the overall portfolio from selling equities at a low price to fund upcoming cash flow needs.

Analysts earnings projections for 2019 dropped from $156 to $155 for a forward price to earnings (P/E) ratio of 18.3. We are still worried that earnings may not grow as much as analysts predict and think a more conservative earnings number for 2019 would be $140. Over the last twenty years the P/E ratio has averaged 19.47. Using the P/E of 19.47 multiplied by earnings of $155 for the S&P 500 Index provides a target of 3018 and a return of approximately 6.5%. Our lower range for the S&P 500 Index is calculated using the ten-year average of the P/E ratio (18.01) multiplied by conservative earnings estimate of $140 and provides a target of 2521 or a decrease of 11% from the current levels. Given the current risk of a 11% drop compared to the reward of 6.5% we recommend that investors maintain their stock exposure at the lower end of their target range with more exposure to value stocks. If we see stronger earnings in the second quarter or an oversold market, we may start moving equity levels up to neutral from low end of the target equity range.

Investing involves risk, including the possible loss of principal and fluctuation of value.  Past performance is no guarantee of future results.

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