Fair Value

Feb 09, 2019 | Dann Cushing


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Somewhat surprisingly, there was an absence of meaningful global trade news during the period...

Somewhat surprisingly, there was an absence of meaningful global trade news during the period despite the highly anticipated US-China talks on Jan 31. That left quarterly earnings as the primary focus for equity markets.

 

Two-thirds of S&P 500 companies have now reported and the trend is clear – Q4 revenue and earnings are better-than-expected, but guidance for 2019 is cautious. To be precise, bottom-up projections for earnings growth in 2019 have dropped to +5% versus 2018’s tax-cut induced growth of +20%.

 

Two notable trends within that are: 1) multinationals are projecting meaningfully lower growth than US companies with domestic sales, which is in part due to currency; and, 2) growth estimates are highly dependent upon a strong recovery in the second half – in fact Q1 growth estimates are actually negative on average.

 

That creates an interesting set-up when juxtaposed with valuations. In the absence of any meaningful friction over the past two weeks, North American equity markets continued to float upward another 1.5% (and lifting your equity portfolios a similar amount). As a result, the market’s forward P/E is now about 16x which is back in-line with its 5-year average. If 2019 earnings growth estimates are low and heavily back-end loaded, why would valuations rise any further from here into above-average territory?

 

To us this suggests that equity markets are now stalled out for the coming quarters, with one major caveat: a positive resolution to US trade issues, which would be very likely cause both earnings estimates and valuations to rise simultaneously, creating a powerful equity market rally. Equity owners are in a tricky spot as a result – invested in a market with arguably more near-term downside than upside, but with very high optionality on an impossible to predict event.

 

One way to take advantage of this would be by using options since the VIX has fallen sharply as equity markets have rallied. Recognizing that is not in scope for most of our mandates though, an alternative is simply to rigorously scrub the portfolio of any positions where our original investment thesis is not evolving and/or of companies where earnings growth is not clearly independent of the overall economy. In other words, beta has been great during this equity market recovery but we can't let it distract from individual security selection. With this backdrop, we will also feel highly comfortable holding cash tactically to deploy either during a renewed market sell-off or promptly following the resolution of US trade issues. The “risk” to this is opportunity cost - but as equity valuations reflate, that's a risk we're happy to take.