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While this is now the longest economic expansion in US history, several important factors suggest the economic expansion has more fuel left in the tank. History suggests another 20% gain for the S&P 500 is a reasonable outcome.
- Business Cycle Indicator Strength – Our quantitative model suggests economic growth will re-accelerate in 2020.
- Global Central Banks are Cutting Rates Aggressively – This is a stark contract to late 2018, when most central banks were raising rates and the S&P suffered a 19% drawdown (12/24).
- Previous instances when the Fed was cutting rates without a recession led to +20% returns over the next 12-months
- Manufacturing Recovery – The US manufacturing sector has been hit hard by tradetensions. Purchasing Manager Indices (PMI’s) have been dismal for much of 2019. However, there are signs that things are turning up.
- Consensus is too Bearish – The average US equity strategist expects the S&P 500 to rise 4.6% in 2020. The consensus is usually wrong.
- More Common than You Think – 13 of the last 50 years (26%) saw the S&P 500 rise 20% or more. 16 of the last 50 (32%) returned 19% or more.
Business Cycle Indicator Strength
The big concern for much of 2019 was the yield curve, which inverted for several months. An inverted yield curve has historically been a reliable sign that a recession was imminent. However, we don’t rely on one piece of data for determining recession risks – this is why BCI exists.
Our Business Cycle Indicator (BCI) combines leading economic data with the best track record of forecasting the US economy. BCI continues to rise into year-end suggesting economic growth is re-accelerating. This is a stark contrast to 2018, when BCI was showing signs of decelerating economic growth.
Building permits logged a new cycle high in October, while heavy truck sales hit a new all-time high in September. Historically, both tend to peak well in advance of recessions.
Historical Look at BCI for Perspective
Our Business Cycle Indicator can be modeled back to 1968. Historically, a reading of -0.9 has preceded every recession. On average, a reading of -0.9 came 8 months before the onset of a recession.
The current environment looks similar to 1995, 1998, and 2016 (green arrows below). In each of those instances, the US economy experienced a ”growth scare”, but a recession did not materialize. The most recent growth scare culminated in December 2018, and BCI now suggests the economy is reaccelerating.
In 1995 and 1998, much like today, the Fed cut interest rates to maintain the economic expansion.
Central Banks Are Cutting – Aggressively
Central Banks around the world are cutting interest rates at a pace not seen since the 2008 financial crisis (above). Central bank policies are the driving force behind economic cycles.
During the last two growth scares (2016 & 2018), more central banks were raising rates than cutting rates (below). Rate cuts reduce the cost of capital and spur economic growth.
At December’s Fed Policy meeting Jay Powell expressed that the Fed would need to see apersistent rise in inflation above its 2% target before they begin raising rates again. Inflation is currently running at a 1.6% pace.
With the Fed on hold, we look to previous instances where the Fed cut rates mid-cycle.
Fed Cuts without a Recession = +20% for S&P 500
Since 1950, there have been five instances where the Fed cut rates without the US entering a recession. Each of those instances lead to the S&P 500 rising more than 20% over the subsequent 12-months.
The manufacturing sector has been hit hard due to uncertainties around trade policy. The ISM Manufacturing survey has been in contraction (below 50) for three months.
Historically, a reading below 50 without the US entering a recession, has led to outsized gains of more than 20% over the subsequent 12 months. The chart below shows the six times that ISM < 50 w/o recession, and the subsequent 12-month return below.
The next ISM release is January 2nd.
+20% Years Are Not That Rare
A look at history shows that returns of +20% are not as rare as one might think. In fact, 13 out of the last 50 years posted returns of 20% or more (26%). Three additional years posted returns between 19-20%.
Nearly a third (32%) of the last 50 years have posted returns in excess of 19%. Given that a recession is unlikely in 2020 (based on BCI), a 20% gain for the S&P 500 is reasonable.
The Consensus is Low – Expects 4.6% in 2020
“Be greedy when others are fearful, and fearful when others are greedy.”– Warren Buffett
Every year, Wall Street strategists estimate where the S&P 500 will end the following year.The average estimate calls for a 4.6% rise in 2020. This annual exercise is largely futile as these estimates are usually way off the mark.
However, it is a good barometer of consensus expectations – which is usually wrong. If everyone is calling for a bear market, there likely won’t be one. Conversely, if every strategist is calling for the market to rally, look out below.
With the consensus looking for modest returns next year (i.e. – not greedy), and a recession not in the cards (which cause the big declines), we find it more likely that the S&P posts a much stronger year that expected.
Positioning into 2020
Our Business Cycle Indicator currently suggests that economic growth will pick up pace in the first half of 2020 (bottom left). Analysis of historical returns based on the current BCI quadrant shows that the S&P 500 averages +1.4% per month. Energy, Materials, Industrials, and Technology posted the highest average monthly returns.
As BCI absorbs incoming data, the expected returns will change throughout the year.
Corrections will happen. On average, the S&P experiences one 10% correction each year. Given the strong run we’re seeing into year-end, don’t be surprised if we see some bumps along the way. Nothing goes up in a straight line. It’s best to prepare yourself mentally for when they come.
What Could Go Wrong?
While we believe the chances of a +20% rise in the stock market are good, we also realize that there are risks.
- Political Volatility / Election Year – The 2020 presidential race will be hotly contested andwill create headlines. Keep in mind that on average, the fourth year is the second best forstock market returns (3rd year is the best).
- Economic Growth Doesn’t Rebound – A key part of our thesis is that central bank actions will lead to an acceleration in economic growth, both in the US and the rest of the world. It is possible that the acceleration does not materialize. We are keeping a close eye on global economic data in addition to our quantitative models for clues/confirmation.
- Inflation Quickly Moves Well Above 2% – The Fed has stated that they will not raise rates until inflation rises above 2%. Rate increases by the Fed are what end economic cycles, and high inflation gives them the green light to hike rates.
- The Unknown – It is foolish to think we can account for everything that will matter to the stock market over the next 12-months. There are always events that come out of left field that at the time, will feel like a really big deal.
The information shared above should not be considered a recommendation to buy or sell any security. Every investor’s circumstances are different. If you’d like to discuss how the above information applies to your situation, contact us.