Nothing to See Here

Feb 18, 2020 | Dann Cushing


The first half of February has delivered another seemingly steamy rally for North American stock markets. Equities have...

...gained 5% over just the first thirty trading days so far this year, which is close to the average return predicted for all of 2020 by market strategists at the large Wall St firms. It also means that equities are now up 15% - 20% in total since the first signs of a trade agreement emerged late last summer.

These numbers lead to a question that we are hearing with increasing frequency in our conversations with clients and other money managers: isn’t this rally getting a little stretched? The financial press has of course seized on this theme as well, most commonly juxtaposing the rally with the fact that there was essentially no earnings growth in 2019. I would argue that this is too narrow of a comparison, and that breaking the past few years into periods logical investment periods provides better context. 

To that end, using rounded returns for the S&P 500:

All of 2017: a strong equity market gain of 20% driven primarily by the once-in-a-generation US corporate tax code change that was completed late in the year

Most of 2018: a gain of 10% in the after-glow of the tax cut and the perceived knock-on effects for the overall economy. Earnings for the year grew 25%...roughly in line with the combined stock market gains of 2017 & 2018.

Winter 2018 – Summer 2019: a market correction and full recovery triggered by the combination of trade war fears and rising US interest rates. The latter were reversed; the former led to a manufacturing recession that remained isolated to that sector.

Fall 2019 – Today: a 15% gain for equities resulting from stabilization in the trade war and a return of business confidence. This includes a 3% drop and recovery (so far) from the coronavirus.

While acknowledging that the starting point of 2017 is arbitrary and also that the above analysis trades quantitative rigour for an intuitive narrative, the conclusion is that only about 15% of equity market returns from the past few years have yet to be “matched” by earnings growth. That is not an unreasonable number, especially since markets are forward-looking and since the baseline for this year’s growth after last year’s manufacturing recession is quite low. The six-month run up in equity markets may feel overdone, but really there’s nothing unusual to see here.

The two points of discomfort that this does not address are: 1) the growing concentration of equity market returns in the largest companies; and, 2) the risk of the coronavirus disrupting 2020 earnings growth. The former is an outstanding issue linked at least in part to the ever-growing impact of passive investing; the latter however is more immediate. On the one hand it is clearly having an impact on businesses, as was just evidenced by Apple reducing its sales guidance for this quarter. On the other hand, it also appears to have taken a meaningfully positive turn with new cases decelerating for almost two weeks straight, with the mortality rate dropping and with contagion in developed markets still not materializing. If this trajectory can be sustained, investors will likely remain willing to ignore near-term noise and stay focused on underlying earnings growth through the rest of the year.