Having declined from 2,925 on October 3 to 2,351 on December 24 (-19.6%), the S&P 500 posted a solid rebound over the last few days of 2018. The index closed the year at 2,506. Despite this rebound, we still think that the outlook of the U.S. equity markets remains negative. As we indicated in our October 28 article "S&P 500 - What To Do Now?", we are not invested in the U.S. equity markets now.
In our view, the renewed concerns on the world economic outlook can take their toll on U.S. equity markets at the beginning of the year. A fresh example of the deteriorating international economic outlook was the decline of Chinese PMI manufacturing index from 50.2 to 49.7 in December. It was the first negative reading since May 2017 and the signal that the world's second-biggest economy could decelerate in 2019. In this scenario, the world economic growth could fall in 2019 below the 3.7% posted in 2017 and expected for both 2018 and 2019 by the IMF.
We think that U.S. economic outlook is not favorable to the equity market. Even if we do not expect a recession to occur soon - at least not in H1 '19 - we think current analysts' earnings estimate for 2018 are too optimistic considering that Nominal GDP growth is likely to be at 4/4.5% pace. According to latest FactSet consensus estimate, analysts are projecting a 5.3% revenue growth and 7.9% earnings growth in 2019.
We see two negative indications for the earnings outlook:
1) Net profit margin (corporate profit after taxes with IVCCA/Nominal GDP) is at a level in line with a moderate earnings growth over the next 5 years. Indeed, historically, high net profit margin has been followed by weak earnings growth in the years ahead. While net profit margin is now below the historical high of 12.4% posted on Q3 '14, it is still at high level (11%) and in line with a moderate profit growth in the years ahead.
2) The flattening of the yield curve - the 10-year/2-year government bond spread declined to 16 basis points on January 2 - is another negative leading indicator for earnings growth. As shown by the following chart, a flat yield curve has anticipated a weak earnings growth over the following 3 years.
For this reason, we expect a downward revision of earnings estimates over the next few months, which could weigh on investors' confidence. The decline of major international equity markets following the revenue forecast cut from Apple is a clear indication in this direction.
Analysts projected a 9.2% earnings growth in 2019 in mid-November. The downward revisions of earnings estimate to a 7.9% growth were one of the reasons behind the sell-off in December. We expect the downward revision to continue in the weeks ahead, especially if economic data continue to point to a weakening of GDP growth in 2019. The consensus estimate is for a 2.4% GDP growth in 2019.
What could make us change our mind
Due to a deteriorating outlook for earnings growth, we would turn bullish on the S&P 500 only in case of:
- A steepening of the yield curve: With inflationary pressures well contained, we think that a steepening of the yield curve could happen only for an unexpected improvement of economic scenario. A pause of the Fed's tightening of monetary policy could be the trigger for a steepening of the yield curve as investors could start reducing the possibilities of a recession.
- The return of the S&P 500 above critical level: Following the correction in December, all the major trend indicators for the S&P 500 are in bearish territory. Only the return above 2,740 could mark the end of the correction started in October.
Despite the rebound over the last few days of 2018, we remain not invested in the S&P 500. The worsening economic outlook could affect analysts' earnings estimates for 2019, which we think are too optimistic at 7.9%. A downward revision of earnings estimates could weigh on investors morale, as indicated by the reaction of major international equity markets to Apple (NASDAQ:AAPL) revenue forecast cut. Only a re-steepening of the yield curve or the return above 2,740 could make us change our mind on the outlook of the S&P 500.
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.