As we approach the end of the year, it’s always a good idea to review what’s happened and how it’s happened and what that might mean for next year. In looking at the S&P 500 for 2018, performance is basically flat. In the chart below (courtesy of the WSJ’s Daily Shot), we can see what has contributed to the index’s return this year. Earnings growth and dividends have contributed nicely to market returns while multiple contraction has offset this growth.
For those that don’t know, a stock market index’s or an individual stock’s annual total return is determined by three factors: 1) annual earnings growth, 2) annual dividend growth and 3) multiple expansion or contraction over the same time frame. Earnings and dividends are pretty straightforward. Earnings are what a business generates after all expenses have been netted against revenues and other sources of income. Dividends are what companies pay out to shareholders in the form of cash usually. Multiples basically represent collective investor sentiment towards stocks as a whole or towards an individual stock. Multiples fluctuate based on positioning within a business cycle, expected growth prospects, anticipated interest rate levels, expected inflation levels and a litany of other potential factors. Multiples expand when investors feel confident earnings, dividends and cash flows are going to grow. In other words, their expectations are optimistic. Multiples contract when expectations are pessimistic and/or when there’s uncertainty. Human nature is first and foremost to discount in the face of uncertainty, often times to zero. As a result, multiple contraction can happen very quickly and often times overshoots.
In looking at how the three drivers of stock and stock index performance interacted in 2018, we can see that multiples contracted the most since 2002, when the economy was in a recession. As of right now, the consensus view is that we’re not in a recession but we usually don’t learn we’re in a recession until after the fact. It’s likely stock multiples have contracted given the general uncertainty permeating the market place as it relates to future earnings growth, future interest rate levels and future global economic growth, which directly affects earnings growth.
The good news is a recession doesn’t appear to be imminent. While slowing, earnings growth is expected to be positive. The Fed Chairman sounded a lot more dovish in his remarks yesterday. The trade conflict between the U.S. and China could substantially clear up after this weekend’s G20 summit. Current stock multiples likely reflect slowing earnings growth, higher interest rates and trade wars. Unless new information that leads to decisively worse expectations enters the equation, further multiple contraction may be less severe or non-existent in 2019.
Overall, stock market valuations look pretty reasonable across much of the world with the U.S. the only market that is at the high end of its 10-year average on a forward multiple basis (see the figure below from Lazard, again courtesy of the WSJ’s Daily Shot). Granted, 10-year averages are backwards looking and don’t necessarily reflect current or future realities. However, unless there’s a general repricing of a market based on structural or secular changes, average multiples in conjunction with cyclical data generally are a good barometer for measuring the attractiveness of a market. Based on the fact we appear to be in the late part of the current cycle, multiples may have more downside risk than upside risk at this time. However, the downside risk may not manifest itself for another year. That year may end up producing solid stock market gains. That’s why market timing is so challenging and probably shouldn’t be practiced by most of us. Stick to your plan and stay invested.