Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: On Wednesday, the Federal Reserve announced another rate hike in December, and said it expects two more in 2019 and one more in 2020. While a December rate hike had long been expected, stocks turned dramatically lower following the announcement. What happened here?
Stovall: I think it was a classic example of buy on rumor, sell on fact. You could say that some stock market prognosticators got what they asked for with a rate hike in December, indicating that the economy is strong enough to handle another rate hike and that the Fed is not being pressured by the President to alter its course.
At the same time, however, we saw the Fed dot plot drop to two potential rate hikes from three, and the Fed indicated that its neutral rate would be in the 2.5-3% range. So, some regarded that as being fairly dovish.
Others regarded the statement as delivering a lump of coal during this holiday season as the Fed left in the language, “some further gradual increases in the target range for the federal-funds rate will be consistent with sustained expansion of economic activity.”
By our measure, that puts a rate hike on the table for the March meeting and maybe one more for all of 2019. Even though the Fed did say they might raise rates in 2020, I think that’s too far out to accurately add to estimates.
EQ: In this week’s Sector Watch, you discussed the heightened concern investors have toward an economic and earnings recession in the near future. Why do you believe these aren’t likely to materialize?
Stovall: I think that the reason investors are starting to become a bit more bearish is because of all the red ink that they’re watching on regular and financial TV. There’s an old saying that prices lead fundamentals, and so while the economic data is not pointing to a recession, I think the hype from the media as well as the price action itself is causing many investors to question those forecasts.
However, I don’t think that we are headed for an earnings recession, and therefore, I don’t see it pointing toward an economic recession. If we use the old rule of thumb for economic recessions in that we need two successive quarters of GDP decline, then we apply that to earnings, you would need to see two successive quarters of earnings declines. Well, in each of the quarters of 2019, consensus Wall Street estimates point to year-on-year increases, they just happen to be lower than the year-on-year gains that we have seen thus far in 2018.
That’s not because we’re headed for recession, but because the bar has been set so high. In terms of 2019’s growth, each of the quarters are expected to post a record in terms of earnings for the S&P 500, but it’s the rate of growth that will be slowing. I think we’re going to have to wait until 2020 before this economy finally slips into recession.
EQ: You argued that the market may be jumping the gun in projecting a recession when in actuality it’s just slowing, albeit significantly. Is the market’s recent volatility just investors recalibrating their expectations to that lower growth or are investors trying to essentially outsmart each other to get ahead of the next recession?
Stovall: Investors typically try to get a jump on other investors around the globe, but I think that the volatility that we’re seeing thus far in 2018 is pretty much as history had predicted. In 2017, we only had eight days in which the S&P 500 rose or fell by 1% in a single day. At the same time, we had a well above average number of all-time new highs. So, history says that in the year after low volatility and a great number of new highs, you end up seeing volatility return to normal.
What is normal? Well, 51 such days of 1% action going back to 1950, and 75 going back to 2000. So, right now, we are around 60 such days, which is higher than the average since 1950 but still well below the average gong back to the end of the tech bubble.
EQ: Recently, you also published your outlook for 2019. Given the expectations for a more challenging environment next year for investors, can you provide a few of the key highlights in terms of your S&P 500 target and weighting recommendations going forward?
Stovall: Essentially, our feeling is to expect a slowdown to really be the driver for 2019. I titled the article “Outlook 2019: Compromising Comps—This Aging Bull Will Need to Vault an Elevated Bar.” We have a full-year 2019 target of 2,975. We are also recommending a reduced exposure to equities, mainly on the large-cap US side, and are now suggesting 40% US equities, 15% foreign stocks, 30% bonds and 15% cash.
Our belief is that share price appreciation will approximate earnings growth for 2019. We think that the value-oriented sectors are going to outperform the growth groups next year. We advise investors to focus on higher-quality stocks, meaning those companies that have more consistently raised their earnings and dividends over an extended period of time.
Also, look toward beta. Look toward lower-volatility ETFs to lead the way in the coming year and just remember the old adage that if you lose less on the way down, you have less you need to recover when the market finally gets back to break-even.
Also, if you have not lightened up on your foreign equities exposure, now might be too late. That’s primarily because Wall Street sees an improvement in earnings for both the Developed International Markets and the Emerging Markets in 2019 as compared with the slowdown in growth for 2019 here in the US.
Lastly, because the Fed is getting close to the end of its rate-tightening cycle, we think that there will be lessening pressure on bonds, and therefore that should increase their attractiveness relative to stocks.
EQ; We’ve discussed a reversion to the mean with regards to international stocks. Is 2019 likely to see that happen or would you temper expectations there?
Stovall: Well, we have our recommendation on foreign exposure as neutral, meaning 15%. So, I would tend to say that on a relative basis you don’t want to give up on your international holdings just yet, but at the same time, I wouldn’t say it’s time to back up the truck, either.
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