2019 Market Outlook: A Look At Valuations And The Yield Curve

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by: Logan Kane
Summary

US equity markets currently sit about 15 percent below their all-time high. International markets are down more.

After the corporate tax cuts, earnings growth, and the recent correction, equity valuations are reasonable across the board.

The bond market seems to be predicting Federal Reserve rate cuts and possibly another round of quantitative easing in the US. This is in stark contrast to the Fed's official position.

If the Fed cuts rates and commences QE4 to bail out a slowing economy and/or housing market, equities could rally sharply.

2018 has been a tough year for equities, albeit not an unusual one by historical standards. At the time of writing this, US equities are down about 5 percent for the year and 15 percent from their all-time high. International equities are down more. This market action has come with a Fed that is insistent on hiking rates despite the stock market going down 500+ points just about every time Jay Powell gives a public talk.

There are two things that the Wall Street consensus will never forecast. The first is down years in stocks, and the second is cuts in interest rates. We look like we've got a down year this year and may get a rate cut next year.

I'm optimistic and think that either:

A. The economy does better than expected and the market goes up or

B. the Fed cuts surprises by cutting rates and resumes QE, and the market goes up.

Equity Valuations are Low

The S&P 500 now trades below 15 times forward earnings estimates, which is historically cheap. Over the last 20 years, the index has traded as high as 25-26 times earnings during the mania of 1999 to briefly below 10 times earnings during the panic of 2008-2009.

If your career started to take off in the late 1990s and 2000s and you feel like the people older than you had an easier time building wealth, it's because they did, at least in their 401(k) accounts.

Stock valuations have fallen significantly over the last 20 years despite solid corporate earnings growth.

Source: I/B/E/S data via Yardeni Research

Over time, equity valuations have shown a tendency to revert to the mean. I wouldn't read too much into the relative valuations of small vs. large cap, but what I would take away is that valuations are fairly low. Historically, valuations predict about 20 percent of future equity returns (r2= ~0.18).

This is both because corporate earnings have come up, courtesy of tax reform, and because prices have fallen, courtesy of Q4 2018. The market is now pricing US equity returns north of 12 percent after the correction. If the Fed continues to hike rates and drives the economy into recession, you may well be early in buying, but it's unlikely you'll be proven wrong in 5 years with a decision to buy stocks.

What About the Fed?

The Federal Reserve (and the Wall Street economists that parrot them) and the bond market are saying two different things right now.

The Fed is predicting two rate hikes in 2019. The bond market is pricing in the possibility of a cut. If you look at history, very few people, least of all the Fed, ever forecast rate cuts. Rate cuts catch investors by surprise. This is normal because if the Fed were to ever actually forecast rate cuts, it would cause all kinds of behavioral problems with the economy. Personally, I think Jay Powell knows he'll have to cut rates when the economy slows down, but can't show his hand without major players in the economy making counterproductive moves with that knowledge.

Historically, when growth comes in below expectations and deflationary pressure shows up in one area of the economy or another, the Fed tends to cut rates quickly. This graph is a little old but shows a consistent pattern of economists overestimating future interest rates.

As I said before, economists rarely predict negative years for stocks or cuts in interest rates.

Source: CNBC

Here's the current yield curve. It's flat compared to where it has been in the past. While not inverted (yet), it's common knowledge among market participants that inverted yield curves typically precede recessions.

A recent blog post from the St. Louis Fed actually argued that inverted yield curves can actually cause recessions by giving banks incentives to hold onto money rather than lend it out.

There are some interesting implications to this. If inverted yield curves truly cause bank lending to rapidly shrink behind the scenes, the Fed might be able to tame the business cycle in the future by managing interest rates better and avoiding inversions.

Source: Guru Focus

Many market participants rightfully view flat or inverted yield curves as negative for stocks. Right now, the yield curve isn't fully inverted, but the one-year Treasury note is yielding more than the two- and three-year Treasuries. This, in my view, means that the market believes that the Fed will either overdo the rate hikes and have to cut interest rates or will not raise rates at all.

There's a risk premium associated with owning bonds, so it's natural for investors to be paid more for taking risk for longer periods of time. The higher rate on the one-year note reflects the risk that investors may have to reinvest their money at lower interest rates if the Fed cuts rates.

The bond market thinks that the economy will slow, perhaps not into recession, but slow nonetheless.

The 10-year Treasury note has taken a dive in the fourth quarter of this year from about 3.2 percent to about 2.7 percent, reflecting investors' need to dial back risk and falling expectations for growth.

The good news about the drop in interest rates is that it effectively neutralizes my bearish thesis on housing. After rising dramatically earlier in the year, mortgage rates have fallen in lockstep with Treasuries. This takes much of the pressure off of the national housing market and makes it cheaper for Americans to do things like buy homes, refinance their mortgages, take jobs in other cities, etc. Lower mortgage rates have a multiplier effect on the economy, so this is a very good sign.

Sure, housing markets on the West Coast and in well-supplied markets like North Texas, Denver, Las Vegas, and South Florida still need to correct about 10 percent in real terms, but if mortgage rates stay where they are or go down, it will happen in an orderly fashion without much fanfare.

If the Federal Reserve resumes the full extent QE to support the economy, the housing market will be the single largest beneficiary. Typically, down-cycles in housing markets last 3-4 years. With a sharp dose of QE, down-cycles in housing could last as few as 12-18 months and be far shallower than otherwise.

Conclusion & Plays

Growth is slowing in the US, without question. However, the Fed has levers it can pull to fire up the economy. I don't agree with its policy of raising rates right now and think it'll have to cut rates, but after the dramatic drop in valuations over the last three months, I feel that equities across the board are priced to reward long-term investors.

I'd feel comfortable deploying liquidity at this point to buy stocks, particularly those that have fallen significantly. For large-cap picks, I like Apple (AAPL), Micron (MU), Boeing (BA), Visa (V), and Microsoft (MSFT).

If you're getting a nice year-end bonus or otherwise have some cash to invest, I think you'll be pleased long-term with the results if you put it to work now. Markets have been volatile lately (and volatility tends to cluster over the short term), so avoid using a bunch of leverage (either via high IV options or using portfolio margin), but right now seems as good a time to put money to work in stocks as any.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.