Outlook 2019: Solving the Math Puzzle - Fidelity Capital Markets
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LEADERSHIP SERIES JANUARY 2019
Outlook 2019: Solving the Math Puzzle
Following the 23% decline in valuations, investors are better
compensated for an uncertain future
Jurrien Timmer l Director of Global Macro l @TimmerFidelity
Key takeaways The market is a three-dimensional puzzle
For me, the stock market is a three-dimensional math
• In 2018 the stock market was caught in the
puzzle that’s both elegantly simple yet impossible to
crosshairs of the discounted cash flow model solve. It’s a paradox that reminds me of many other
(DCF), with a temporary earnings boom fully aspects of life.
offset by a falling P/E multiple. I am a firm believer in the discounted cash flow model
• In 2019, I think we will get more clarity on both because it reflects all the major pieces of the stock
the earnings side and the interest rate side of market puzzle: earnings, interest rates, valuation, and
sentiment. The problem is the DCF requires three inputs:
the DCF.
earning, rates, and the risk premium. Predicting each
• If growth in earnings per share (EPS) individually is hard enough, but getting all three right
moderates to 5% to 7% and the U.S. Federal is close to impossible. But that’s what we need to do to
Reserve stops at or below the neutral rate solve for valuation—and therefore price.
(around 2.5%), then P/E valuations could put According to the DCF, the market’s fair value—or the
us in reasonable shape for 2019. price investors should be willing to pay for each dollar
of future earnings—is driven by sustainable earnings
• But if earnings growth comes in substantially growth (the numerator, or E) and the cost of capital (the
below that range, or the Fed commits a policy denominator, or r). The latter is the sum of the risk-free
error, then the correction of 2018 likely will rate (10-year Treasury yield) plus an estimate of the equity
continue well into 2019. risk premium (ERP).If we could solve for the market’s fair value (its price-to- 2018: A year of market purgatory
earnings ratio, or P/E), the rest would be easy in that the This puzzle has been playing out in a big way. 2018 will
direction of stock prices simply becomes a function of go down as the year when earnings growth boomed
earnings growth and the P/E. So, if we could know the E (up 24%), yet the stock market moved only sideways.
and the r, then we could know the P/E, and once we knew Aren’t stock prices supposed to follow earnings? Well,
the P/E we could potentially solve for the P; easy! (NOT! historically they have over the long run, but the degree to
Quite difficult, actually...) which they do so depends on where valuations go, and
It’s basic math. For example, if the S&P 500 is trading at a ®
that depends on liquidity conditions, risk premia, and the
17x P/E multiple and earnings grow by 10% and dividends sustainability of earnings growth.
yield 2%, then the index will return 12%. If, in addition, While the 24% growth rate in calendar year (CY) 2018
the P/E ratio expands to, say, 19x, then the return jumps earnings is surely impressive, it was never going to be
from 12% to 25%. That’s a big difference—and a good sustainable, in my opinion, and investors tend not to pay
reminder that while most people tend to focus on price for temporary earnings spikes. With CY2019 earnings
levels (“Where’s the Dow trading?”), what really matters growth estimates already falling from roughly 12% to
is valuation, i.e., what investors are willing to pay for each below 10%, the 2018 spike has proven to be fleeting.
dollar of earnings. So, it’s the combination of earnings and
valuation that drives price in the stock market.
EXHIBIT 1: Will 2019’s earnings estimates follow the most common historical path?
EPS Estimates Drift by Calendar Year and Overall (2005–2018; 2019 Projected)
180 176
Expected EPS (NTM) 173
170 Actual EPS (LTM) 169 168
2005–2017 160
160
2018 158
150 2019
Typical progression
140 137
136
132
130 130
124
120
118 117
112 116 117
110 109 109
103 103
100
93 94 96
90
87 83
85 84
80
76
70 72
60 60
50
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Sources: FactSet, DataStream, Fidelity Investments; monthly data through Dec. 8, 2018.
Past performance is no guarantee of future results.
2OUTLOOK 2019: SOLVING THE MATH PUZZLE
Not that 10% is anything to sneeze at, but it’s not 24%. investors were willing to pay for each dollar of current and
Meanwhile, companies’ cost of capital has been rising projected earnings. Is that enough of a concession? To me,
as the U.S. Federal Reserve has been tightening its that’s the big question as we head into 2019.
monetary policy at a steady clip and credit spreads have Obviously, U.S. trade tension with China is playing a large
widened. As a result, liquidity conditions have grown role in this re-rating, given the stagflationary impact that
more restrictive. That affects the DCF’s numerator. protectionism can be expected to have on the economy
Between investors worrying about the sustainability of and therefore corporate profits. For those with a zero-sum
earnings growth and the tightening of financial conditions, mindset, it can be tempting to assume that tariffs will hurt
the net result has been that the market’s P/E has under- only Chinese companies. But the reality is that, to varying
gone a substantial de-rating in 2018. At the S&P 500’s degrees, a price will be paid by everyone, including
January 26 peak of 2873, the forward P/E—based on U.S. consumers and companies. Tariffs could either
projected EPS for the next 12 months (N12M)—was 19.5x, cause prices to rise (if companies can pass costs on to
and the trailing 12-month P/E was 21.9x. At its October consumers) or cause profit margins to shrink (if they can’t),
low, these S&P 500 P/Es were down to 15.0x and 16.7x, neither of which is good for equity valuations. The risks to
respectively. That’s a 23% devaluation in terms of what the supply chain are formidable as well, given the “just-in-
time” inventory structure of today’s global economy.
EXHIBIT 2: 2018’s EPS estimates were somewhat of an anomaly
Progression of Earnings Estimates by Calendar Year (2013–2018; 2019 Projected)
Year-over-year EPS growth estimate
24% 2013 24.0%
2014
22%
2015
20% 2016
2017
18% 2018
16% avg of 2013–2017
2019
14%
11.9%
12%
9.0% 10.6%
10%
8%
6%
5.0% 5.0%
4% 4.4%
2%
0%
–1.2%
–2%
–52 –39 –26 –13 0 13 26 39 52 –2.0%
# of weeks into calendar year
Source: Bloomberg Finance L.P.; weekly data through Dec. 8, 2018.
Past performance is no guarantee of future results.
3Solving the puzzle for 2019 5% to 7%, in line with the historical trend of 6% to 7%. By
I think 2019 will probably prove a continuation (and my math, that translates to a CY2019 EPS of $168 for the
likely a conclusion) of the themes that have been driving S&P 500 overall; current estimates are for $173 and, for
markets in 2018. First: Where is earnings growth heading the last 12 months (LTM), $158. Even the lowered $168
now that the temporary spike has worked its way through number could have downside risk if U.S.–China trade
the system, and how sustainable will it be? Is the EPS tension escalates further.
growth rate 10%? 5%? Zero? Second: What will happen to the cost of capital, which
Consensus estimates for CY2019 are at 9.3% and drifting in turn affects EPS estimates (Exhibit 3)? This will largely
lower, as they’ve historically had a habit of doing as the depend on what happens to Fed policy in 2019 (which
months pass. Companies are inclined to under-promise could affect the risk-free rate), as well as market sentiment
and over-deliver, so estimates tend to fall leading up (impacting the risk premium).
to a reporting period (Exhibits 1 and 2). If the historical We know the Fed has raised its federal funds target rate
progression of earnings estimates is any guide, chances eight times—by a total of 200 basis points (bps) since late
are that CY2019’s EPS growth rate will end up at around 2015—and just went for a ninth hike. On top of that, the
EXHIBIT 3: Earnings growth and the Fed cycle track fairly closely
Federal Reserve Rate Hikes Compared with Expected EPS Growth (2013–2018; 2019 projected)
12 11.9 30%
28%
11 24.5% 25.7% 26%
24%
10
22%
9.4 20%
9
18%
8 16%
14.0% 14%
7 12%
10%
6 6.3% 8%
6%
5 5.2% 6.2% 4%
2%
4 0%
–2%
3
–4%
2 –6%
# hikes: actual + priced in by curve –8%
–7.0%
1 Expected EPS growth rate –10%
–12%
0 –14%
Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 Oct-16 Apr-17 Oct-17 Apr-18 Oct-18 Apr-19 Oct-19
Sources: Bloomberg Finance L.P., Fidelity Investments; weekly data through Dec. 8, 2018.
Past performance is no guarantee of future results.
4OUTLOOK 2019: SOLVING THE MATH PUZZLE
Fed has been further tightening financial conditions by autopilot (one hike per quarter) to a more data-dependent
shrinking its balance sheet. We also know that the Fed’s policy may be in order.
so-called dot plot—depicting all 16 Federal Open Market I think this makes sense for a number of reasons. First,
Committee (FOMC) members’ individual projections “R-Star”—the neutral real interest rate at which monetary
of where the policy rate will be—has been suggesting policy is neither accommodative nor restrictive—is a
another five hikes over the coming two years (now down theoretical construct that cannot be observed in real time,
to two, following the December 18 hike), a prospect that so as we get closer to it, it’s wise for the Fed to not get
the market has been struggling with the past few months. too formulaic in terms of how or when it gets to the end
More recently, following a broad-based deterioration in of its normalization process. In this way, with his now more
various market barometers, Federal Reserve Chair Jerome pragmatic risk-management approach, Chairman Powell
Powell has hinted that he may slow the pace of remaining seems to be channeling former Chair Alan Greenspan a bit.
rate hikes as the Fed has now gotten closer to the low end Second, while the 11% sell-off in the S&P 500 earlier this
of what it considers the neutral zone (estimated to be in year was never going be enough to sway the Fed, the
the range of 2.5% to 3.0%). That suggests a switch from more recent 11% decline has been different. Unlike the
EXHIBIT 4: What the Fed watches: a sampler
TIPS Break-Even Rates (top) and Credit Spreads (bottom)
3.4 3.3
3.2 3.1
3.0
2.8
2.8
2.6
2.4
2.2
2.0
2.0 2.0
1.8 1.9
10yr Note
1.6 US 5y5y Breakeven
1.4 5yr TIPS Breakeven
1.2 1.3 10yr TIPS Breakeven 850 230
1.0 750 210
190
650 170
High Yield OAS 138 550 150
IG OAS
430 450 130
110
350 90
80 250 70
Nov-12 May-13 Nov-13 May-14 Nov-14 May-15 Nov-15 May-16 Nov-16 May-17 Nov-17 May-18 Oct-18
TIPS refers to Treasury inflation-protected securities. The break-even rate refers to the difference between the yield on a nominal fixed-rate bond and the real yield on
an inflation-linked bond of similar maturity and credit quality. The credit spread is the yield spread that must be added to a benchmark yield curve to discount a
security’s payments to match its market price, using a dynamic pricing model that accounts for embedded options. The 5y/5y breakeven is a measure of expected
inflation (on average) over the five-year period that begins five years from today.
Sources: Bloomberg Finance L.P., Fidelity Investments; weekly data through Dec. 8, 2018.
Past performance is no guarantee of future results.
5January/February correction, the October/November If the forward curve is correct and the Fed is almost done,
correction has been much more broad-based, affecting then I think this should be a fairly benign outcome for
not only stock values but also credit spreads, commodity rates and liquidity conditions, which feed into the DCF’s
prices, and inflation expectations. The Fed rightfully pays denominator. That, of course, still leaves the Fed’s balance
attention to all of these inputs (Exhibit 4) and, at least to sheet taper as an unknown risk, as its effect on liquidity
me, they all seem to be screaming, “Slow down!” conditions remains difficult to quantify.
This dovish pivot, needless to say, has been welcomed So, let’s assume that earnings grow 5% to 7% in 2019 and
by the markets, not only because it diminishes the risk the Fed stops hiking the fed funds rate at the 2.5% to
of a policy error, but because it gives investors better 2.75% level. That suggests to me that the risk-free rate
clarity on where this Fed cycle may end and when. With (10-year Treasury) is reasonably priced at around 3.0%. If
a ninth rate hike announced after the FOMC meeting on the implied equity risk premium (currently running roughly
December 18–19, the bond market is now expecting just 2%) remains as is, then the overall cost of capital should
one more hike for the cycle, sometime in 2019. In fact, be supportive at around 5%: That’s near historical lows.
the forward curve starts to decline beyond 2019, which In my view, positive earnings growth combined with a
means that many in the market have begun to price in a reasonable cost of capital should produce a modestly
rate cut in 2020 (Exhibit 5). favorable outcome for the stock market, and is supportive
EXHIBIT 5: Are we there yet? Markets are contemplating an end to Fed hikes
Treasury Yields and Expectations for Federal Reserve Interest Rate Actions
3.4
12.8
3.3 3.3 3.2
12.2
3.2
11.6
3.1
11.0
3.0
10.4 3.1
2.9
9.8 2.8
2.8
9.2
2.7 9.3
8.6 2.6 10yr Tsy
# hikes next 2yrs 1.0 1.1 2.35
8.0 2.5 1.0
2.3 2.30
7.4 2.4 0.9 2.25
0.8
6.8 2.3 2.20
0.7
6.2 2.2 0.6 0.6 2.15
5.6 2.1 0.5 2.10
US real 10yr 0.4 2.05
5.0 2.0
5y5y TIPS B/E 0.3 2.00
0.2
1.95
0.1
0.0 1.90
–0.1 1.85
–0.2 1.80
May-17 Jul-17 Sep-17 Nov-17 Jan-18 Feb-18 Apr-18 Jun-18 Aug-18 Oct-18 Dec-18
Sources: Bloomberg Finance L.P., Fidelity Investments; through Dec. 8, 2018.
Past performance is no guarantee of future results.
6OUTLOOK 2019: SOLVING THE MATH PUZZLE
of mid- to high-single-digit gains in 2019. That’s assuming A Federal Reserve policy error seems less likely now
no further re-rating or de-rating in the stock market’s that the Fed has already pivoted away from its hawkish
P/E ratio, which is currently registering around a 15x to stance of a few months ago, and the scenario of a Fed
16x multiple. If valuations move up from here, we could needing to cut rates seems like an outlier to me, given
quickly get into the double digits in terms of total return. the apparent strength of the U.S. economy.
But if valuations continue to contract as they have done Option A is something that’s harder to predict, in my view.
so far in 2018, further compression of P/E multiples could While I see little or no evidence of a U.S. recession on the
offset any earnings gains, leaving the market with little or horizon, many market professionals are sounding the alarm
no progress in 2019. of an ever-flattening yield curve. The predictive value of
an inverted yield curve is well-documented of course, and
What are the risks?
with the long end of the bond market now falling back
The obvious risk to this relatively benign outcome is that
below 3% and the Fed expected to raise rates at least one
(A) earnings growth slows much more than expected—
more, the spread between the 10-year yield and the 2-year
or even contracts; and/or (B) the Fed commits a policy
yield (the 2y10y curve) is on the cusp of inverting.
error either by raising rates past the market’s ability to
withstand or by failing to cut rates if and when needed.
EXHIBIT 6: Looking back to 1994 may prove a useful analogy for today’s yield curve
Comparison of the 2-Year Forward Yield Curve and the S&P 500, Start Point 1994 Versus Recent Past
3100 3350
3200
3000
3050
2900 2900
2800 2750
2600 S&P 500 starting in 1994
2700 S&P 500 index
2450 2yr-FF: 2018
2600 2300 2y-FF: 1994
2150 2yr-FF adj for 1994 term premium
2500
2000 231.1 219.9 250
2400
1850 200
2300 1700 199.8 150
100
58.6 50
0
-50
Sep-15 Mar-16 Sep-16 Mar-17 Sep-17 Mar-18 Sep-18 Mar-19 Sep-19 Mar-20
Sources: Bloomberg Finance L.P., Fidelity Investments; through Dec. 8, 2018.
Past performance is no guarantee of future results.
7I suspect these inversion fears will prove premature. Most has been distorted by the negative term premium. (The
market folks are pointing to the 2y10yr curve, but I have term premium is the excess yield investors require to
never been a fan of that spread, instead preferring the commit to holding a long-term bond instead of a series
3m10y (10-year minus 3-month yield) curve as a purer of shorter-term bonds). In 2014, after years of quantitative
expression of the term structure. And the fact is that, at 46 easing and low inflation expectations, the historically
bps, the 3m10y spread is still positive by about two Fed positive term premium turned negative. For instance,
hikes (assuming no change in the 10-year Treasury yield). taking the 1994 Fed cycle analog (which bears a striking
According to the forward curve, that’s likely more hikes resemblance to today’s cycle in terms of the direction of
than we will get anyway. So let’s take a breath, people. both the stock market and the yield curve), if we adjust
And even if the curve were to invert, it remains to be seen today’s negative term premium for the positive term
how effective that signal would be during this particular premium back, then you can see how much further the
cycle, given the degree to which the shape of the curve curve would be from inverting today (Exhibit 6).
EXHIBIT 7: Rebalancing act: Are we in good shape for 2019?
S&P 500 Levels Tracked with Forward P/Es and the Goldman Sachs Financial Conditions Index
2939.9
2950 S&P 500 19.7 98.1
19.8
2900 98.2
19.6 P/E–NTM
19.4 2850 GS Fin’l Conditions Index 2814.8 98.3
19.2 2800 98.4
19.0 2750 98.5
18.8 2700 98.6
18.6
2650 98.7
18.4 2631.5
18.2 2600 98.8
2550 2603.5 2583.2
18.0 98.9
17.8 2500 2532.7 2553.8
99.0
17.6 2450 99.1
17.4 2400
17.2 17.1 99.2
2350 16.9
17.0 99.3
16.8 2300
99.4
16.6 2250
99.5
16.4 2200
16.2 99.6
2150 16.2
16.0 16.1 99.7
2100
15.8 99.8
2050
15.6 99.9
15.4 2000
15.2 100.0
15.2 1950 15.2
15.0 1900 100.1
Jul-17 Aug-17 Sep-17 Nov-17 Dec-17 Jan-18 Mar-18 Apr-18 Jun-18 Jul-18 Aug-18 Oct-18 Nov-18
Sources: Bloomberg Finance L.P., Haver Analytics, Fidelity Investments; daily data through Dec. 8, 2018.
Past performance is no guarantee of future results.
8OUTLOOK 2019: SOLVING THE MATH PUZZLE
Conclusion With investors embracing the inverted yield-curve
With the caveat that the discounted cash flow model is an playbook and worrying about U.S.–China trade, it’s easy
impossible-to-solve riddle, my sense is that the slowdown to see why markets are so nervous, but in my view a 20%-
in earnings growth from 24% in 2018 to possibly 5% to plus haircut in the P/E ratio is decent compensation as we
7% in 2019, against expectations that the Fed will hike head into 2019 (Exhibit 7).
rates only once or twice more, is not such a bad outcome. Needless to say, if we are heading into a recession and
The question, then, is: What’s the right valuation? What an earnings contraction, then all bets are off. But at this
is the P/E haircut that is warranted for a scenario in which point there’s little evidence that this will happen in the
earnings growth is decelerating (but remains positive) U.S. any time soon.
and the Fed is still tightening but stops short of neutral?
Is a 15x forward P/E multiple and a 16.7x trailing P/E
multiple enough of a concession?
Author
Jurrien Timmer l Director of Global Macro, Fidelity Global Asset Allocation Division
Jurrien Timmer is the director of Global Macro for the Global Asset Allocation Division of Fidelity Investments, specializing
in global macro strategy and tactical asset allocation. He joined Fidelity in 1995 as a technical research analyst.
9Information provided in this document is for informational and educational purposes only. To the extent any investment information in this material is deemed to be a recommendation, it is not meant to be impartial investment advice or advice in a fiduciary capacity and is not intended to be used as a primary basis for you or your client’s investment decisions. Fidelity and its representatives may have a conflict of interest in the products or services mentioned in this material because they have a financial interest in them, and receive compensation, directly or indirectly, in connection with the management, distribution, and/or servicing of these products or services, including Fidelity funds, certain third-party funds and products, and certain investment services. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk. Nothing in this content should be considered to be legal or tax advice, and you are encouraged to consult your own lawyer, accountant, or other advisor before making any financial decision. Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Please note that there is no uniformity of time among business cycle phases, nor is there always a chronological progression in this order. For example, business cycles have varied between 1 and 10 years in the U.S., and there have been examples when the economy has skipped a phase or retraced an earlier one. Investing involves risk, including risk of loss. Past performance is no guarantee of future results. Diversification and asset allocation do not ensure a profit or guarantee against loss. All indices are unmanaged. You cannot invest directly in an index. Index definitions Standard & Poor’s 500 (S&P 500®) index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. S&P 500 is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation and its affiliates. Goldman Sachs Financial Conditions Index tracks changes in interest rates, credit spreads, equity prices, and the value of the U.S. dollar. A decrease in the index indicates an easing of financial conditions, while an increase indicates tightening. Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC. If receiving this piece through your relationship with Fidelity Institutional Asset Management® (FIAM), this publication may be provided by Fidelity Investments Institutional Services Company, Inc., Fidelity Institutional Asset Management Trust Company, or FIAM LLC, depending on your relationship. If receiving this piece through your relationship with Fidelity Personal & Workplace Investing (PWI) or Fidelity Family Office Services (FFOS), this publication is provided through Fidelity Brokerage Services LLC, Member NYSE, SIPC. If receiving this piece through your relationship with Fidelity Clearing and Custody Solutions® or Fidelity Capital Markets, this publication is for institutional investor or investment professional use only. Clearing, custody, or other brokerage services are provided through National Financial Services LLC or Fidelity Brokerage Services LLC, Member NYSE, SIPC. © 2018 FMR LLC. All rights reserved. 870034.1.0
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