Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio & Technical Strategy.
The S&P 500 is breaking out to new highs today on reports that a potential phase 1 trade deal with China is getting “very close.” Current headlines suggest that US trade negotiators are not only offering to delay the December 15th tranche of tariffs, but also cut the rate on existing tariffs by 50%. The market had been consolidating some of its gains recently as December 15th approached, as investors made sure those tariffs got delayed. So if the current headlines come to fruition, it would obviously be an added boost to market momentum. The cut in existing tariffs would improve 2020 earnings expectations marginally but, more significantly, ease the sentiment headwind for both corporations and investors. On the other hand, a disappointment on trade is likely to cause a normal pullback in our view.
The S&P 500 currently trades at a P/E of 19.3x, which we view as reasonable considering the low inflation and interest rate environment, as well as the potential for global manufacturing trends to improve in 2020 as trade tensions ease. We apply a fair value S&P 500 P/E of 19.25x to our 2020 base case scenario, so the majority of next year’s upside is likely to come from earnings growth in our view (following 22% P/E expansion in 2019).
As referenced above, earnings are set to improve from a very slow 1.2% growth rate in 2019. Granted, 2019 earnings had tough comparisons following 2018’s 22% earnings surge on tax reform. These comp headwinds ease in 2020, and we forecast S&P 500 earnings to grow to $174 (5.5% growth in our estimates) next year. Applying this $174 in earnings to the 19.25x P/E gets us to a base case S&P 500 target of 3,350 in 2020. This is 6% above today’s current level (before dividends), and would obviously look more attractive on a slight pullback.
Technical: The S&P 500 breakout supports continued momentum over the intermediate term. As such, we would continue to accumulate favored sectors and stocks, and use pullbacks as buying opportunities. The small caps have held above their breakout point over the past week and look set to continue their advance over the intermediate term. Small cap relative strength has yet to break out (vs the S&P 500), but trends have stabilized and could be turning higher. At the sector level, we have a cyclical bias to our recommendations- overweight Technology, Communication Services, Health Care, Financials, and Industrials sectors. The industrials have not gotten overextended in the short term, and we believe you can look to this group to buy broadly as they attempt to build upside momentum.
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