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2020 Stock Market Outlook Thumbnail

2020 Stock Market Outlook

“In 2019 we’ll see a corporate earnings recession, 2% GDP growth, escalating trade tensions with China, and President Trump will be impeached. Against this backdrop, U.S. stocks will surge over 25%, the Barclays Aggregate Bond Index will return over 8%, and Gold will be up over 15%.”

Was this your 2019 prediction?

Think back to the end of 2018. Global equities declined materially in Q4 2018 and we came within .2% of bear market territory (peak to trough loss of more than 20%). In fact, December 2018 was the stock market’s worst December since the Great Depression. The concerns going into 2019 were widespread: slower earnings growth, the U.S.-China trade dispute, the direction of interest rates, geo-political risks, and unpredictable news out of Washington. We entered 2019 in a state of fear.

So, what actually happened? Well, most, if not all, of our fears were realized: corporate earnings dipped into recession territory, economic growth slowed, additional tariffs were levied against China, and news out of Washington was, well, unpredictable.

And………

Markets rallied - U.S. Stocks up +25%, bonds up +8%, and Gold up +15%. Needless to say, 2019 was a good year for investors.

But why?!

Like most times of market stress and volatility, the end of 2018 paved the way for opportunity as negative market sentiment, reasonable starting valuations, and low interest rates set the stage for positive (or just not as negative as expected) news to surprise on the upside. Let’s explore in more detail.

Market Sentiment 

“Be fearful when others are greedy and greedy when others are fearful.” – Warren Buffett

Investor sentiment is usually a contrary indicator - when investors are optimistic, markets disappoint, and when investors are pessimistic, markets outperform. This may seem counter-intuitive, but it makes sense when you consider the nature of human emotions. When times are good, we feel confident, embrace risk, and bid up the prices of risk assets (stocks) to unsustainable and unwarranted levels. And when times are bad, we feel scared, embrace fear, and selling pressure pushes risk assets into bargain territory.  

Below is a chart from CNN’s Fear & Greed Index over the last three years.


A low score represents extreme fear, and a high score extreme greed. At the end of 2018, the index was at a three-year low. Ordinary investors were scared and wanted nothing to do with stocks. But eventually the selling stopped, and cool-headed (and often professional) investors were able to pick up stocks at bargain prices. This, in turn, helped fuel a rally of over 12% over the next three months.

In contrast, investors felt confident in early September 2018 and the index was approaching greed territory. Ordinary investors came to the market to buy stocks at expensive levels only to watch the value of their shares decline almost 20% over the next three months.

Market sentiment matters - it pays to follow Warren Buffett’s advice.

Valuations

“High valuations entail high risks.” – Ben Graham

When looking at the forward price/earnings ratio, stocks entered 2019 at their cheapest levels in five years.

To be fair, valuation is not a good short-term leading indicator (cheap markets can get cheaper and expensive markets can get more expensive), but against a backdrop of low interest rates, stocks looked especially attractive. This is no longer the case due to 2019's stock market rally. Today, valuations are back to late 2017 levels.

You can think of the P/E ratio in the same way you think about price per square foot in real estate. All else being equal, you would prefer to buy when the price per square foot is low (compared to both the market and history).

Interest Rates

“The current stance of monetary policy is likely to remain appropriate.” – Jay Powell, Chair of the Federal Reserve

Without question, the biggest tailwind for asset classes in 2019 was the Federal Reserve’s decision to cut interest rates three times to a range of 1.5%-1.75%. The moves were a significant change of course for a Fed that had steadily raised rates since late 2015. Low interest rates allow companies and individuals to borrow cheaply and support higher valuations for stocks, high yield fixed income, and real estate, as investors in search of attractive yields and higher returns are forced to embrace riskier asset classes.

So, what’s going to happen in 2020?

Predicating the short-term direction of the stock market is a fool’s errand - your guess is as good as mine. That said, we still need to be mindful of current market signals, indicators, and common sense. Looking out at conditions today, the market looks and feels similar to the end of 2017 (optimistic investor sentiment and elevated valuations) - the following 12 months would be marked by wild swings and a negative annual return.

Will 2020 follow 2018’s playbook? It could, but there is reason to believe that this rally could persist due to low interest rates, low probability of a recession, and a rebound in corporate earnings.

While we can’t control the stock market, we can control how we prepare for the uncertainty around us. For my clients, this means getting ahead of any known liabilities (down payments, tuition, loans) and having at least six months of living expenses in cash or short duration fixed income.

One thing we know for certain is that volatility and market stress are part of being a stock market investor – volatility will return. But if you’re prepared, any losses will be just paper losses.

Regardless of what happens, please keep in mind that the stock market has been the single biggest contributor to wealth. As long as you remain invested and keep fees low, you will make money over time.

So, here’s to an unpredictable 2020. I look forward to reporting back to you at this time next year.

Optimistically yours,

Ryan