2019 Stock Market Outlook: Is A Recession Coming?

We are sure investors are pleased to turn the calendar from 2018 to 2019! The stock market was on a roller coaster in 2018. US Large Cap stocks were up approximately 8% through the end of September 2018, only to give up approximately 13 percentage points during the final 4th quarter. After all the dust settled from a fast and furious sell off in December, here are the final 2018 stock market results:

US Large Stocks -6%
US Small Cap Stocks -12%,
Non-US Stocks of developed countries -16%.

2018 in perspective: the past three years have been pretty good for investors, as the following data illustrate:

2016-2018:
US Job growth: 7.2 million
S&P 500 Corporate Profit Growth: 38% (25-28% excluding the 2018 corporate tax cut)
S&P 500 Index: +23%

2019 OUTLOOK FOR THE STOCK MARKET

We expect the stock market to perform well in 2019, due to bearish investor sentiment, modest inflation, low interest rates, corporate earnings growth, and an attractive stock market valuation (price-to-earnings ratio).

Stock Market Sentiment - History is clearly on the bulls’ side; and we expect the US stock market to be up in 2019. Why should we be so optimistic one may ask? There have been only four times since 1929 that the stock market was down in two consecutive years. And most importantly, individual investor sentiment is extremely bearish right now, which is a bullish signal for the stock market. Individual investors tend to “sell” when fear is in the markets, and “buy” when markets are rising and most optimistic. According to the American Association of Individual Investors (AAII) survey, the sentiment index reading is in extreme bearish territory right now. The last two times this reading was this bearish, the S&P 500 Index was up double digits during the subsequent 12-month period. While this survey is an encouraging signal, we look at economic and market conditions to guide our outlook.

Interest Rates - At the end of September 2018, the Federal Reserve Board (Fed) stated it will raise interest rates by ¼ point, and then in early October 2018 Fed Chairman Powell stated additional rate increases in 2019 are likely. This statement spooked the stock market, which began its descent through December 2018. In December 2018, Fed Chairman Powell calmed the markets by stating the Fed will remain flexible, “data dependent”, and not apply a rigid interest rate policy. So, if the US economy begins to show weakness, the Fed, in our opinion, will likely hit the “pause button” on increasing interest rates. The Fed’s dual-mandate continues to be full employment and price stability as defined by the personal consumption expenditure index (PCE), rising annually by approximately 2.0%. The current PCE index is currently rising annually by 1.8%. We resist the temptation to forecast interest rates because they are of the most volatile and difficult variables to predict. Just three months ago, the 10-year treasury yield was 3.2%, only to fall to the current 2.7%. The important message is that the Fed should be flexible and adjust interest rate policy as needed.

Inflation - Appears to be well under control at the current time with the PCE index rising at 1.8% annually.

Trade - China-US trade negotiations are having a direct impact on the markets. When there has been even a sniff of negative or positive movement with China-US trade negotiations, the stock and bond markets have responded rapidly. Markets are currently expecting concessions from China by the March 1, 2019 deadline. If “No Deal” is reached by March 1, 2019, the US will place a 25% tariff on $200 billion of Chinese imports. The art of these negotiations is to have both China and the US save face and claim victory. US demands to China include: eliminating tariffs, respecting intellectual property rights, and removing the joint venture requirement for companies investing in China. We expect there will be concessions by China but certainly not everything the US demands. If China agrees to purchase additional US exports and allows for a path for intellectual property rights protection, we believe the market will respond positively.

IF NO CONCESSIONS ARE MADE BY CHINA, WE EXPECT THE 25% TARIFF WILL BE IMPOSED MARCH 2, 2019 ON $200 BILLION OF CHINESE EXPORTS TO THE US AND THE STOCK MARKET WILL SELL OFF SIGNIFICANTLY.

Economic Growth - While the US economy grew a strong 3% in 2018, most economists and strategists, including The World Bank, are forecasting the US economy to grow by 2.5% in 2019. A 2.5% GDP growth rate should provide the economic environment for companies to increase earnings by 6-8% in 2019. The job market continues to be strong with 312,000 new jobs created in December 2018. While this was in December 2018, it shows that employers are generally optimistic about their business prospects.

Market Valuation - The stock market’s price-to-earnings (P/E) ratio is 14.6x and is at a five-year low. The low P/E ratio provides an opportunity for P/E expansion in 2019, which may occur if trade negotiations with China exhibit progress and prospects of a recession in 2019 or 2020 recede. 

 

WHAT COULD GO WRONG IN 2019? QUITE SIMPLY… A RECESSION.

As the 1970s comedians Cheech and Chong said “recession… oppression… depression… they are all the same man…a real bummer!”

Recessions are a normal part of the economic cycle and are almost always associated with capital (money) supply declining dramatically, as asset prices become excessive. The last two recessions exemplify this phenomenon.

The 2000-2002 bear market and recession (mild) was due to the .com era when capital investment was flooding internet companies, many of which had little or no revenue. The primary source of this funding was wall street and suddenly this funding stopped. The stock market (S&P 500 Index) declined 50% from its high when its P/E ratio was a staggering 27x. After the sell-off, the stock market’s P/E ratio was 14x, slightly lower than the stock market’s P/E ratio’s historical 15-16x range.

The 2008-2009 bear market and recession (severe and deep) was caused primarily by the housing market. The reason this recession was so severe is because it was the banking system that was at risk. Financial institutions were holding securities or derivative securities of the housing sector. Housing prices had been rising well above inflation and zero down payment loans (sub-prime) were being made to risky borrowers. Once again, capital was shut off by various US Government guaranteed mortgage purchasers: Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac); and various buyers literally around the world. Panic entered the financial markets requiring extraordinary government intervention by the Federal Reserve system and the US government to reverse the economic downward spiral.

While no two recessions are exactly alike, they are typically precipitated by excessive speculation.

What could be the cause of the next recession?

  1. The economies of Europe and China slipping into contraction (recession), which could drag the US economy into recession.
  2. Business investment stalls due to China-US trade negotiations.
  3. The Federal Reserve makes a policy error by raising interest rates too high and thereby choking-off business and/or consumer demand.
  4. The credit worthiness of the US Government comes into question, and US Treasury Bond buyers demand increasingly higher interest rates for their bond purchases. This would expand greatly the US Government fiscal deficit and require our government to finally bring entitlement expenses under control.

No one rings the bell to recessions. They unfold step-by-step then suddenly one becomes apparent.

WE ALWAYS ADVISE: Invest in the stock market for the long term (at least 3 years+) and have sufficient cash available for emergencies and spending needs for 2-3 years. We are optimistic about the US economy and the stock market over the long term, with many technological initiatives under way which could transform many industries and consumers’ purchases.

Rich Lawrence, CFA January 13, 2019

DISCLOSURE:
This market commentary includes data we believe to be accurate. However, Lawrence Wealth Management (LWM) does not warrant or guarantee its accuracy. Opinions about the future are not predictions, guarantees or forecasts. Investing in stock and bond markets have risks that could lead to investors losing money.

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