Outlook for 2019: Evaluating the Overall Risk/Reward Setup

Around a year ago, I wrote a piece about how I use the annual forecasts of Wall Street strategists to deduce a range for where I think the market will finish the year.

My goal with this exercise is not to nail a precise earnings-per-share estimate or price target for the S&P 500. As a money manager, I’m simply trying to evaluate how good or bad the overall risk/reward setup is.

Expectations and fundamentals both play roles in determining the overall market’s trajectory. And one of the best times to evaluate expectations is at the turn of the year, when the annual market outlook derby commences.

To simplify, I limit my forecast range to just the following four choices:

*     “Up-a-Lot” (+15% or more)

*     “Up-a-Little” (flat to +15%)

*     “Down-a-Little” (flat to -15%)

*     “Down-a-Lot” (-15% or more)

Diagnosing the right range will not tell you everything you need to know to invest well. But it can help determine things like an appropriate target beta for your portfolio, and which sectors to emphasize. 

In my column a year ago, I predicted 2018 would be a “Down-a-Little” year. And I got that right. The S&P 500 finished the year down 4.4%, while mid and small-cap stocks declined about 11%.

Getting the market range right wasn’t exactly a profit panacea for my portfolio, but it helped mightily in the fourth quarter. I was overweight defensive sectors that hung in relatively well, while more cyclical stocks sold off sharply.

But that was last year, this is this year.

Using the same process, let’s turn our attention to 2019.

2019 Market Outlook

The consensus view on Wall Street this year is “Up-a-Lot.” Investment strategists tracked by Bloomberg have a median year-end target for the S&P 500 of 2,980 (+19%).

I’m not as optimistic as them, but I am more bullish than last year.

In 2019, I predict U.S. stocks will finish “Up-a-Little.” Here are some of the reasons why.  

We’re coming off a down year. Since 1926, stocks have averaged a 12.4% return following negative years. Back-to-back negative years happen from time to time, but it’s rare. Mean reversion to the upside seems a more likely outcome in 2019.

Sentiment has reset. A year ago, everyone was talking about the “globally synchronized recovery.” Today, most market watchers perceive the global economy to be in a cooling-off period. In the financial media, there is a lot more debate about the potential for a looming recession.

I spilled a lot of ink in articles last year warning about the investment implications of a growth slowdown. A lot of my worry was because of the ebullient sentiment environment. A growth slowdown isn’t a huge deal. It’s only dangerous if few people are expecting it.

However, a lot of the downside risk I worried about quickly materialized during the fourth quarter, and sentiment has since adjusted. 

Based on my go-to economic indicators, I think it’s hard to argue a recession is right around the corner. If I’m wrong about that, the market will probably be down a lot this year. But if I’m right, this recent shift toward more economic apprehension will likely prove contrarian bullish, because it sets a better stage for upside surprises. 

It’s also worth noting that as economic sentiment dimmed, so too has investor sentiment. Investors Intelligence recently reported a Bull/Bear ratio below 1.0 for the first time since February 2016. Historically, that type of reading has been a bullish contrarian signal. Since 1969, readings under 1.0 were followed by an average 17.5% gain over the next year. 

Lower interest rates. The U.S. 10-year yield drifted up to 3.2% last November, and the Fed hiked their target rate four times in 2018. Consequently, interest-rate-sensitive areas like housing and autos became dismal performers in 2018.

Rates have fallen in recent months, though. The 10-year is down to 2.7%. And the Fed has started telegraphing a more dovish tone. Lower rates help alleviate financing costs for consumers and businesses and are a positive for equity valuations.

Better value. This one is simple. The S&P 500 traded at 20x forward earnings at the start of 2018. Now it trades at 15x. Cheaper is better.

Lower commodities. American consumers just got a sizeable tax break in the form of lower commodity prices. Bloomberg’s Commodity index declined 13% in 2018, largely due to plummeting oil prices in the fourth quarter.

At this stage of the cycle, inflation appears a bigger risk than deflation. Thus, I view the commodity pullback as a positive for the market setup in 2019. It alleviates the profit margin pressure associated with rising input costs and helps keep consumer prices in check.  

U.S. Presidential Cycle enters a sweet spot. Even though there are ongoing trade tensions with China, Europe faces policy uncertainty tied to Brexit, and Washington is dealing with a government shutdown, don’t forget or dismiss where we stand in the Presidential cycle. The average return in Year 3 of a Presidential term is above-average at 17.8%. And there hasn’t been a negative return in Year 3 since 1939.

***

Based on my more positive view this year, I’m no longer overweight just defensive sectors. Too many high-quality cyclicals were on sale in December to pass up.

If you’re defensively positioned, I would consider opportunistically adding risk. If you pick your spots carefully and stick with the right criteria, I think you’ll be rewarded.

What qualifies as “the right criteria?” This could be a long answer, but I’ll shorten it to the two points I think are most critical.

Favor strong balance sheets. Corporate leverage is at an all-time high. And based on leverage ratios alone, history says over half of the investment grade bond market could be rated junk status. Don’t trust rating agencies to do your homework for you. We all know how that turned out in 2008. I don’t think we’ll face another credit dislocation of that magnitude anytime soon. But there will be pockets of turmoil. To avoid trouble, simply stay away from firms that have above-average debt-to-equity ratios compared to their peers.

Note: If you don’t know how to screen company peers, or how to contextualize things like debt-to-equity or interest coverage ratios, that’s ok. Just don’t buy individual stocks! A broad market ETF tracking an index like the S&P 500 is a fine choice for most people.

Favor high-profit firms. With the U.S. economy operating at full-employment, corporate profit margins will be pressured. As that happens, firms possessing a healthy and steady margin cushion become more valuable.

Now is a good time to favor the type of companies Warren Buffett likes. He favors firms that are like an “economic castle,” with strong moats that prevent competitors from intruding.

Morningstar employs analysts who do a good job diagnosing which firms qualify as “wide-moat.” You can subscribe to their research if you like to pick your own stocks. They also offer an ETF, which has outperformed since 2012. Ticker symbol: MOAT.

I wish you a healthy and prosperous 2019!