For equity investors, 2019 was a highly gratifying year. The major stock indices recorded one of the strongest results of the last 20 years. The European stock indices ended the year between +12.1% (FTSE100) and +30.6% (SPI), and in the USA, too, the prominent indices were clearly up at year-end (+28.9% S&P 500, +22.3% Dow Jones). What can equity investors expect from the stock markets in the coming years? In order to find an answer here, it is worth analysing the factors determining the return on equity investments individually.
The total return on an equity investment is made up of the price change and dividends. The price change, in turn, is driven by two components: a fundamental component, which is based on profit growth, and a valuation component, which reflects how much investors are prepared to pay for this profit growth.
In the short term, equities fluctuate with the general stock market sentiment. In the medium term, stock prices should reflect the fundamentals – i.e. corporate earnings growth. In the course of the last year, signs of a weakening global economy have become more pronounced, which has led to lower expectations for profit growth. At the beginning of 2019, the US equity market was expected to post earnings growth of around 7% (Europe: 6%), while effective earnings growth in the US is likely to have been just under 1% last year (Europe: 0-1%). At the beginning of 2020 these earnings growth expectations for the US are around 10% (Europe: 11%). Last year’s strong price gains were not fundamentally underpinned: profits rose much less than share prices. Weaker profit growth is typical for the late phase of the economic cycle: companies are confronted with lower sales growth and fewer opportunities to increase margins.
Lower profit growth and still a record year on the stock markets? Most of last year’s price gains can be attributed to the valuation component: an estimated 80% of the gains on the stock markets can be attributed to a general increase in the value of shares. The reason for this stock market rally in an environment of weaker economic and earnings growth was the reversal of US monetary policy in January 2019. Instead of the interest rate hikes still expected at the end of 2018 by the US Federal Reserve, the Fed reduced key interest rates in three steps by a total of 75 basis points in 2019. In the European Monetary Union, the ECB has also made monetary policy even more expansionary in view of the gloomy economic outlook. In an environment of expansive monetary policy and with the prospect of zero and negative interest rates for a longer period of time, there is virtually no alternative for investors. This TINA argument (There is no Alternative) has driven global equity markets in 2019 and has pushed them to higher valuation levels. Measured by the P/E ratio (price-earnings ratio), the valuation of the US stock market is currently at around 20, which is well above the long-term average of 16.
Both the fundamental component (weaker earnings growth) and the valuation component (high valuation) suggest lower returns for the broad equity markets in the late phase of the economic cycle. When expectations for the market as a whole are lower, individual stock selection is particularly important. Equities of companies that benefit from a structural trend should have potential for sales growth and margin increases even in a weaker economic environment. Such structural trends can result from changes in consumer behaviour (trend towards online purchasing) or technological advances (automation, robotics). Similarly, companies with a strong market position are more likely to defend or even expand their market shares even in a weaker market environment, and thus increase their profits more strongly than the market as a whole, even in a weaker economic environment.
In stock selection, special attention is also paid to the third component of total return, dividends. Here, attention should be paid not only to the dividend yield, but also to the dividend quality: how sustainably can the company pay dividends without compromising business prospects in a weaker economic environment? Investors should pay attention to dividend security and the potential for dividend increases.
“The tide lifts all boats, even those with holes in the hull” is an old stock market rule. After a record year on the stock markets, the valuation of the shares is exaggerated and at the same time the growth prospects are clouded. A solid stock selection will become more important again in the future in order to be able to achieve attractive returns even in this more difficult environment.
