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Oarsman Outlook: January 2020

January 10, 2020

The final three months of 2019 featured robust results from nearly all investment categories. The advance was paced by 8% to 10% gains by both large- and small-company U.S. stocks. Overseas, developed and frontier markets rose a bit less, though the emerging-market category surged more than 11%, on average. Real-estate investments were mixed, though timber-related issues soared nearly 15%. Commodity vehicles gained: gold rose 3% and industrial commodities jumped 7% (oil gained almost 13%). Bond yields drifted higher (the 10-year U.S. Treasury finished at 1.92%, compared with 1.68% on September 30), constraining investment-grade returns; narrowing credit spreads propelled stronger gains by high-yield issues. 

Among large-company U.S. stocks, relatively better performance came from companies in the Financial Services, Health Care and Technology sectors; Consumer Cyclical, Staples, Energy and Utilities lagged. Value-oriented stocks outperformed growth issues in the large-cap arena, though the pattern was reversed among small caps.


The fourth-quarter rally capped a remarkable 2019. The year began with investors reeling from a near-20% stock-market plunge that sullied 2018's closing weeks. That debacle was caused largely by fear that global central banks – led by a U.S. Federal Reserve 'on auto-pilot' (in the ill-considered words of Chair Jerome Powell) – were intent to 'normalize' monetary policy (i.e., raise interest rates) despite clear signs of faltering global growth. Meanwhile, an inexorable ratcheting up of trade-related tensions between the U.S. and China weighed heavily on both investor and business sentiment. The remarkable market resurgence that unfolded over the course of 2019 – featuring double-digit gains in nearly every major asset category – was underpinned by reversals in these powerful headwinds and came despite scant improvement in underlying economic or corporate performance.

Global economic activity continued to moderate from the stemmy pace achieved in 2017 and early 2018; by the time final figures are tallied, 2019 will likely show the slowest rate of expansion since 2012. The U.S. economy expanded at an average pace of 2.4% in the year's first three quarters – in line with the norm for the eleven-year-old expansion, but well off 2018's 3.1% clip. A manufacturing-sector slowdown linked to flagging overseas demand, trade-policy uncertainties and a strong U.S. currency was partially offset by healthy growth in the much larger and more domestically oriented service sector. Consumer spending remained solid, supported by a resurgent residential real-estate market buoyed by falling mortgage rates and a firm labor market that added almost two million jobs through November. Unemployment hit a fifty-year low of 3.5%, though wages grew a slightly disappointing 3.1%.

Overseas growth was widely disappointing. The manufacturing- and trade-dependent Eurozone economy was hampered by upheaval in the automobile industry and uncertainties related to trade policy and the EU/UK relationship. Near-recession conditions in Germany and Italy, the continent's first and third largest markets, limited aggregate growth to just over 1%. The Japanese economy, too, was hamstrung by slowing trade and sluggish growth in China and related Asian markets; a midyear consumption-tax hike assured a lackluster expansion (under 1%). Emerging markets were plagued by recession/near-recession in important economies: Argentina, Brazil, Mexico, Russia, South Africa, Turkey; the Indian economy, too, experienced a notable deceleration, though growth was nearly 5%. Finally, the Chinese economy labored against government efforts to curb debt and avoid re-inflating a property bubble, while slowing trade dampened the manufacturing sector. Growth of just over 6% was the slowest in nearly 30 years.

A 180-degree shift in global monetary policy – in response to flagging growth, a renewed decline in inflation and rioting financial markets – was the year's singular event. Having ended 2018 signaling the likelihood of two or more rate hikes in the New Year, the Federal Reserve ended up cutting benchmark rates three times, while also curtailing the shrinkage of its balance sheet by resuming longer-dated bond purchases. In its quest to shore up flagging growth the Fed was hardly alone, as the European Central Bank, Peoples Bank of China, Bank of Japan and a host of second- and third-tier banks opened the monetary spigots anew. By October, nearly two-thirds of the world's central banks were officially easing – a figure that stood near zero in late 2018.

The flood of liquidity released by central bankers – combined with investor fears of spreading economic malaise – had a profound effect on global bond yields. The U.S. benchmark 10-year Treasury Note yield, which traded near 2.8% in January, had by late August plunged to 1.45% – just basis points above the all-time low seen during 2016's global deflation scare; and nervous investors warily eyed a 'yield-curve inversion' (when longer-term yields fall below short-term ones) – historically a reliable harbinger of recession. Meanwhile, the total value of European and Japanese bonds trading at yields below zero climbed inexorably, reaching a peak of more than $17 trillion. Better economic news beginning in autumn caused recession fears to ebb and yields to rise modestly, allowing the U.S. yield curve to resume a more normal configuration and trimming the negative-yield debt mountain to a mere $11 trillion.

With top-line growth hard to come by, the expansion of corporate profits all but ground to a halt. Having seen S&P 500 earnings expand at a robust 22% clip in 2018, Wall Street analysts began the New Year eyeing a more sober but still healthy 10% gain. But slowing overseas growth, the manufacturing-sector slump and the headwind created by 2018's appreciation of the dollar prompted the largest trimming of estimates since 2016. Meanwhile, reported earnings for the twelve months through September were less than 3% above the year-earlier tally.

What's Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

  1. Dividend Income (for three months this is the annual yield divided by four)
  2. +/- Change in Earnings per Share* (average for S&P 500 companies)
  3. +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

* based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to produce the +9.1% S&P 500 total return?

Fourth Quarter (October-December) 2019
Dividend Income+ 0.5%+9.1%
+ Change in Earnings+ 0.4%
+ Change in Valuation+ 8.2%
= Total Return+9.1%

Our read: Having fallen to zero last quarter, we are encouraged by the positive change in year-ahead earnings. Continued growth is needed to validate recent strong market gains.


If 2019's stellar market performance owed much to surprisingly accommodative central banks and receding trade-war angst, underlying economic and corporate performance may need to improve if 2020 is to see further gains – particularly in light of what have become eye-watering valuations. Unfortunately, we don't see a lot to suggest that a major uptick is in the cards.

Global economic activity seems to be bottoming, but we expect any near-term pick-up to be muted. Developed economies seem to lack catalysts for meaningfully faster growth, particularly in light of trade-policy and election-year uncertainties. Given lackluster growth and nonexistent inflation, a supportive policy tilt is almost certain to remain in place, but major central banks have little scope for further stimulus. And while some important actors (e.g., Germany) have room to ease fiscal policy, there is little political will to do so (though a recently announced Japanese spending initiative is a noteworthy counterexample). Finally, Beijing has clearly signaled its focus on slowing debt accumulation and reining in corporate-sector risk, consistent with a willingness to tolerate slower growth. One potential bright spot: other emerging markets have considerable scope for monetary easing and could simultaneously benefit from a weaker dollar: those less closely linked to China – e.g., Brazil, India, Turkey – could surprise to the upside.

Happily, the proportion of economists expecting a near-term U.S. recession has dropped markedly over the past several months – a trend seemingly corroborated by a steepening yield curve. But despite its evident momentum, the American economy also exhibits some worrisome tendencies: the average workweek has been falling; wage growth looks toppy; the purchasing-managers employment sub-index is declining; and consumers rate their 'current situation' worse than a year ago (despite huge financial-market gains).

If the economy holds up (or improves), earnings will grow, but by how much? Restrained wage pressures and a weaker dollar are potential plusses. Limited pricing power and higher energy/commodity costs loom as negatives. Corporate share buy-backs, which increase per-share earnings by reducing share count, declined precipitously in 2019 (from 2018's record pace) and seem set to fall again, judging from a dip in announced repurchase authorizations. Wall Street analysts are predicting a gain of more than 10%. We wouldn't be surprised if, as usual, the final tally comes up short by several percentage points.

Political uncertainty – broadly defined to include foreign/trade relations in addition to the upcoming presidential campaign – may be an under-appreciated risk. The 2020 election seems sure to be unusually volatile and divisive. Rising fortunes of one of the more progressive candidates could cause market jitters, and whoever becomes the Democratic nominee will likely be pilloried as a business-hating socialist. Malign foreign actors may judge the timing propitious for provocation. And, depending on the vicissitudes of polling data, economic news and stock-market swings, we don't doubt Donald Trump's willingness to 'wag the dog' for political advantage. Meanwhile, the much anticipated but rather modest 'phase one' US/China trade agreement seems unlikely to lead anytime soon to the sort of 'grand bargain' – seeing off fears of 'peak globalization' – that investors keenly desire. Both sides in the presidential race want to be seen as 'tough on China.' And the array of contentious issues between the world's two largest economies is sufficiently complex as to defy quick resolution. For 2020 at least – and we would venture a long way beyond – a tenuous 'trade truce' seems more likely than a lasting peace.

The combination of 25%+ price gains and near-stagnant earnings produced a prodigious increase in stock-market valuation during 2019. According to the Leuthold Group, a composite valuation measure combining ratios of prices to earnings, sales, book value and cash flow recently showed U.S. large-cap stocks roughly 20% more expensive than at the average of six post-1990 market peaks. Extending this analysis reveals an unappealing reward-to-risk ratio: if valuation were to reach the highest post-1990 reading on all measures, the gain would be less than 10%; conversely, were it to fall to the lowest reading, the decline would be more than 60%. The text-book solution in such circumstances is to reduce stock exposure in favor of bonds and/or cash. But with fixed-income yields near multi-decade lows, that would seem to lock in disappointing returns. Accordingly, while taking some profits may be a prudent near-term tactic, the best intermediate- to longer-term strategy may be to trim holdings of the most expensive stocks (i.e., U.S. large-caps) while adding to less expensive ones. Small-company stocks have gradually become more attractive relative to the rest of the U.S. market over the past 24 months; Leuthold Group research suggests they offer the best relative value since the early 2000s. And following a decade that saw U.S. stocks advance 13% per year while non-U.S. ones managed only 5%, overseas equities have reached their cheapest relative valuation in over 40 years. We believe a portfolio shift favoring these two categories improves the odds of achieving attractive returns over the intermediate term, albeit at the likely cost of greater short-term volatility.

As we look back on the past twelve months, we are struck by remarkable changes in many key variables. Today's readings on trailing investment returns (eye-popping), earnings growth (meh), valuation (nose-bleed) and investor sentiment (frothy) could hardly be more different from a year ago. Then, we opined that prospective returns might be the best in years; now, we suspect recent gains may represent borrowing from the future. In any case, the current market environment surely reflects a fair amount of good news – and perhaps expectations of more to come. Near-term developments could support further gains, but we are mindful of a heightened potential for disappointment. Caution and patience may be useful watchwords for the New Year.

We thank you for your continued support and encourage you to let us know what is on your mind. Please call or email any time – and happy New Year!