Americas CIO View

The analysts' bottom-up and strategists' top-down estimates for 2019 S&P 500earnings per share (EPS)have been cut from 10% growth at September end to 5% now. A giant deceleration in S&P 500 EPS growth from 22% in 2018, or 15% excluding the tax-cut benefit, is now the widespread consensus view. However, there is a wide range in strategists' 2019 end S&P 500 targets, i.e. strategists have very different views on what the price-to-earnings (P/E) ratio should be.

We forecast 4% S&P 500 EPS growth in 2019, but this includes a 15% decline in the Energy sector profits. Excluding Energy, our S&P 500 EPS growth estimate is 5.5%; which it has been for more than six months. Our intrinsic S&P 500 valuation model suggests a fair trailing S&P 500 P/E of 18, but our target is 16.75x our 2019E S&P 500 EPS given uncertainty in several geopolitical issues; which include U.S. – China trade terms, Brexit and other issues that make it uncertain if enough caution is built into our EPS estimates. There are good reasons to argue for a higher or lower S&P 500 P/E multiple from our 16.75 target, we list five of the top reasons on our mind for each. But we see upside from the current 16.0 P/E and while we think 16.75 is a decently balanced S&P 500 P/E target, we think a climb to 17 to 18 is likely if the expansion shows more signs of lasting at least two or more years and 10-year realU.S. Treasuryyields (TIPS) do not exceed 1.5%.

1. Real long-term interest rates are much lower than historical values

The real 10-year yield is below 1%. The U.S. Federal Reserve Board (Fed) will be patient and is quite close to the neutral rate in our opinion. We think real 10-year yields stay below 1.5% for the rest of this cycle. This is much lower than the 2-3% norm in 1960-2007.

2. Low inflation and subdued inflation uncertainty, low ULCs

Since 1960, the average S&P 500 P/E is 18.0 when inflation and unit labor costs (ULCs) were below 4%. The average S&P 500 P/E was 14.0 from 1960-1984 and 17.7 since 1985. Today inflation and ULCs appear well contained at about 2%.

3. Higher triple-net equity returns: Lower fees, tax rates, and inflation

Equity investment fees are lower, dividend and long-term capital-gains tax rates are lower than historical values, and inflation is lower. Today, equity investors reap higher triple-net returns: 1) after fees, 2) after taxes, and 3) after inflation.

4. The weight of typically higher P/E sectors in the S&P 500 is above history

Technology, Communication Services and Health Care are 40% of the S&P 500 by earnings weight now vs. 15% in 1985. These tend to be higher P/E sectors.

5. Higher S&P 500 net margins are structurally sustainable

S&P 500 business mix has shifted to higher margin industries that have had success in replicating their business domestically and globally. Higher margins than historical values boost the ability of the index to absorb cost shocks.

1. Robust late-cycle EPS growth is often met with investor skepticism

The observed P/E tends to be above average on cyclically depressed EPS and below average on cyclically peaked EPS. It is common for robust-late-cycle EPS growth and the resulting EPS to be questioned for its sustainability. S&P 500 EPS must demonstrate its sustainability by delivering 5% plus EPS growth.

2. S&P 500 P/E rarely expanded during Fed tightening, fear of policy mistake

It is rare for the S&P 500 P/E to expand while the Fed is hiking. However, the S&P 500 P/E at 16 right now is below recent levels and our 16.75 P/E target is a level sustained and exceeded in prior hiking cycles. Post December, the Fed is now more conscious about over-hiking risks and is expressing more patience.

3. Global slowdown leads to greater fear of recession

The record-long expansion and now global slowing raise recession fears. We acknowledge this “soft landing” uncertainty and will monitor the situation to adjust our P/E accordingly. As of now, we consider our 16.75 S&P 500 P/E fair.

4. S&P 500 P/E is rarely above 17 beyond two years after recession

S&P 500 P/E bigger than 17 beyond two years after a recession is rare. But it happened when the mid-cycle slowdown did not turn into a recession and the cycle proved to be long, such as late 1960s, late 1990s, and recently 2016 to 2018. It is also rare that long-term interest rates are this low after 10 years of expansion.

5. Elevated-geopolitical risks globally

Trade tensions and Brexit are the two biggest known upcoming risks, but we think that in either case a compromise is still the most likely outcome for both.