“Returns in 2019 were almost entirely driven by multiple expansion (trailing P/E +12%)”, BofA’s Savita Subramanian wrote, in BofA’s official year-ahead 2020 equity outlook. “Our 3300 S&P 500 target and $177 2020 EPS estimate imply returns solely from EPS growth”.
That pretty much says it all. We’ve obviously spent a ton of time in these pages discussing the extent to which this year’s gains in equities were down to investors’ willingness to pay more for a dollar of earnings. We’ve also suggested that might not be a safe assumption in the new year, as central banks may be less willing to underwrite risk-taking having used up a good portion of whatever scarce ammo remained after a decade of accommodation.
There are good reasons to doubt any narrative that leans too heavily on the assumption that US corporate profits are set to rebound after the first quarterly contraction since 2016. After all, labor costs are rising, buybacks are likely to recede (even as the corporate bid remains robust in aggregate) and it’s by no means clear we’re out of the woods yet when it comes to tariffs menacing margins. Plus, there’s evidence to suggest that pricing power is limited.
And yet, if you believe markets are forward-looking, you might be inclined to say that if part of last year’s Q4 swoon was market participants looking ahead to a negligible profit growth in 2019, gains logged in the final quarter of this year represent investors pricing in an improving outlook for corporate bottom lines in 2020.
According to a pair of recent studies cited by Bloomberg in a Saturday article, stocks and profits typically move in opposite directions in real time. If stocks are falling amid robust EPS growth, it could be because the market expects profit growth to slow going forward, and vice versa.
One of the studies the linked article cites is from Ned Davis. The gist of it is that when corporate profits rise 20% or more in a given year, US equities rise just 2.4%, while in years when bottom line growth clocks in at less than 5%, the S&P jumps more than 12% on average.
In 2018, profit growth was among the best on record, and yet stocks suffered their worst performance since the crisis, for example.
Fast forward to 2019, and stocks are up an astounding 29% even as profit growth has all but flatlined.
Ned Davis memorialized their findings in the following December 20 tweet:
— Ned Davis Research (@NDR_Research) December 20, 2019
Obviously, the risk is that stocks have it wrong in 2019 – that profits do not rebound in 2020 either because the economy rolls over or because margins contract more sharply than expected or, in an extreme scenario, because political developments end up forcing market participants to price in a rolling back of the tax cuts.
A tangential worry is the well-documented disparity between S&P profit margins and profit data based on the National Income and Product Accounts (NIPA). There’s more on that in the linked post below.
In any event, one thing most observers seem to agree on is that the idea that stocks can rise another 30% in 2020 purely on multiple expansion is far-fetched.
“Since 1960, years with significant P/E multiple expansion (like 2019) have been followed by years with slight multiple compression, on average”, BofA’s Subramanian notes.
In other words, profit growth really – really – needs to rebound if equities are keen on printing ever higher highs in the new year.
Read more: S&P 500 Vs. NIPA: The Great Profit Debate