Author: Randy Watts

Attached is the latest Strategy View–Yield Curve from Randy Watts, our Chief Investment Strategist, and Global Sector Strategist Kenley Scott.

Key points:

• This week’s selloff sent major indices to more than 10% off highs, just a few trading days from all-time highs. In this report, we detail past 10% or greater corrections in both bull and bear market scenarios.
  • In bull scenarios, the median depth is ~12% over 36 days. The next leg higher is typically a weaker-than-normal (11%), at up just 9%. This makes sense as the tendency after such a shock is to sell into strength.
  • In bear scenarios, the median depth is also 12%, and the bounce is even weaker, at just 7%.
  • We would not suggest buying the weakness and need to see several days with lows established at a minimum before becoming more constructive.
• With earnings season mostly complete, the good news is that Q4 earnings surprised to the upside, as is typical. The bad news is that 2020 estimates are still too high and continue to steadily decline.

Key points:

• Surprisingly, given the fact that the U.S. is by far the largest market (~54% of the developed market cap and ~40% of the global market cap), the top 20 U.S. market cap stocks are also growing faster than the top 20 stocks elsewhere.
  • The 18% median EPS growth rate over five-years for U.S. stocks is the best in the developed world, and second to only Russia/Turkey across all 47 developed/emerging markets.
  • In the developed world, the top 20 U.S. market cap stocks also have the second highest five-year sales growth rate and pretax margins are tied for the fastest projected earnings growth rate next year and highest ROE.
  • Compared to the emerging world, the top 20 U.S. companies are tied for second in pretax margins and remain first in ROE.
• Given the superior growth and low interest rates which have fueled valuations, it is no wonder the U.S. market is among the best performing over five years.
• On valuation (forward 12-mo P/E), the spread between the S&P 500 and Asia/Europe/Emerging is at ~15-year highs.
• While the setups argue for a reversion trade, similar to the value/small-cap trade in the U.S., a reversion in favor of international markets that lasts longer than a couple of months is unlikely without a pickup in growth relative to the U.S.

Key points:

• Median S&P 500 sales are expected to grow 4% in Q4 2019, roughly in line with Q3. EPS is expected to grow 4%, versus 6% in Q3, but given normal ‘beats’ of 3%, we expect growth of 6–7%.
  • Health Care is once again expected to have the best growth. Six sectors including Technology and Cyclical are expected to show EPS declines.
• S&P 600 growth is lower, with sales and EPS expected at 3% and -1%, respectively. Further, more than 100 small caps could show negative earnings, so the true growth number would be closer to -5%.
  • No sectors are expected to show particularly strong earnings growth, but Financial and Health Care have solid sales growth estimates.
• Estimates continue to fall.
  • Q4 2019 actual (operating) earnings are expected at -2% versus +8% six months ago.
  • Q1/Q2 2020 estimates have come down sharply over the period as well.
  • However, full-year 2020 estimates have only fallen from 11% to 9%, implying a sharp Q3/Q4 2020 rebound.
  • We think the 2020 number is too high, but also think the market is clearly pricing in a rebound.
• Indices are extended currently. The S&P 500 is 10% above its 40-WMA. When it gets this far extended, it typically pauses or falls a bit over the forward four weeks but is higher still further out.
• We remain extremely positive in terms of sentiment given a sharply higher number of leaders (USFL count at a six-year high) and strong action in growth leaders. Still, we would trim very extended ideas ( AMD, NVDA, etc. ) and keep purchases to stocks coming out of new bases ( BL, NOC, PYPL, QCOM, AVLR, CMG, EL, etc. ).

Key points:

• The S&P 500 has risen ~22% over a two-year period, roughly in line with total earnings growth over that time.
• The generic expectation for S&P gains this year could be seen as roughly in line with expected mid-to-high single digit earnings growth.
• We think multiple expansion is more unlikely, but higher gains could come from a pickup in growth.
• The signs of a pickup are not yet here however. In fact, the opposite is true, as is evidenced by the value/cyclical/small-cap outperformance (versus large growth) and international market outperformance (versus the U.S.) which is already starting to wane after just one quarter.
  • Growth has quickly resumed its leadership role. While this is welcome for our strategy and we see plenty of names to buy (Technology, Health Care, Payments, etc.), it is unlike prior market recoveries/breakouts in 2012–2013 and 2016–2017, where value/cyclical/small cap/international led for several quarters.

Key points:

Global markets end the year on solid footing. Historically, years with similar annual gains are typically positive the next year.
The value/cyclical trade is global in nature but likely does not have legs for longer than a quarter or two more.
The broadening into value, confirmed by high breakout totals in the U.S. and developed markets, is a positive nonetheless.
There is risk in continued U.S. earnings deceleration and in the lack of a global growth recovery.
The U.S. is our favored developed market and will remain so until signals from its relative performance tells us differently.
The U.S. presidential cycle heavily favors third years ( 2019 ), with fourth years still being positive, but more moderately so.
After an annual gain of 20% or more, the following year is up 8% on aver­age and is positive two-thirds of the time.
Sectors with biggest potential: Energy ( catchup ), Health Care ( combined 2019/2020 growth and catchu p), Technology/Financial ( 5G, semis, soft­ware, payments, financial services ).
Europe and Japan ( near 25-year highs ) also have very favorable trends. Hong Kong has im­proved but remains riskier.
Top themes: luxury goods, multi-channel/specialty retail, outsourcing, health care ( pharma, supplies, systems/equip ), alt energy, semis/equip.
Emerging markets had a more mixed year, but large markets now generally have positive trends. Favored markets include Brazil, China ( A-Shares ), Taiwan, and India.
U.S. dollar weakness would be a welcome boost.
Recent South Korea/South Africa participation adds fuel.
Top themes: financials, consumer products, health service, semis/equip.

Key points:

• The deceleration of median sales and earnings growth for S&P 500 companies abated, as growth equaled that of Q2.
• Sales growth of 4% and EPS growth of 6% matched the lowest totals since Q2 2016 and Q1 2016, respectively.
• Versus an EPS bar that was lowered significantly coming into the quarter, companies beat by a median of 3%, which has been typical of the past several years.
• Health Care was the clear large-cap standout, with best growth and beats and an acceleration in growth from Q2. Tech, Staples, and Cyclical were among the weakest.
• On valuation, a much lower 10-year yield supports higher stock valuations, and as long as earnings remain positive, the market should move higher. However, Q4 earnings estimates are still being lowered, notably for small caps, meaning we are not at a clear bottom yet.
• Similar to the corrections of 2011–2012 and 2015–2016, sector rotation has favored small-cap, value, cyclical, and industrial initially (and coincided with ~1.5% 10-year yield).
  • Because of this our Focus List count has not increased much since October’s bottom. This should change if the rally persists and/or accelerates.

Key Points:

• A very strong first 10 months of the year has led to better-than-average returns in November/December.
  • Since 1900, in 33 years when the DJIA has gained 15%+ in the first 10 months of the year, November averages a 2.7% gain and December averages a 2.2% gain. This is much better than the November and December averages of 0.4% and 0.8%, respectively, in all other years.
• A very strong annual gain, however, does not lead to better or worse average returns the following year.
  • Since 1900, in 34 years of a 20% DJIA annual gain, the following year averages a 7% gain, versus an 8% gain for all other years.
• The current market leg on the DJIA of 8% is still well below the bull market average up leg of 14% and median of 11%.
• The current shift of styles to value outperformance is similar to the conclusion of the 2011–2012 and 2015–2016 corrections. In those cases, it persisted for 2–3 quarters before fading.