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Stock valuations around the world have risen substantially during the bull market (see chart 1), especially in the US. The higher valuations suggest lower returns going forward and greater risk of substantial drawdowns.
As such, we think investors would do well to look outside the US for high-quality value or cyclical stocks, many of which trade at a discount to the broader market. Some of these companies have strong balance sheets, capable management teams and other high-quality attributes but may be undervalued because they are tied to the economic cycle.
We also believe investors should consider off-the-beaten-path small- and mid-cap stocks. Together, these types of equities could serve as the building blocks of a sustainable risk/reward portfolio in 2020.
Source: Bloomberg. P/Es based on forward 12-month earnings estimates.
Which market themes could be particularly relevant to the year ahead?
We believe a recession in the US would trigger a global sell-off in equities. In addition, we think the relative performance of high-growth stocks versus high-quality value/cyclicals could be a key point of differentiation in performance in 2020, regardless of the economic environment.
How have the experiences of 2019 shifted your outlook for 2020?
In our opinion, 2019 was about multiple expansion – not earnings growth – despite mounting economic and political worries. Consequently, we believe the stock market is much more vulnerable to bouts of psychological fear than in recent years.
Is there a key indicator to watch next year?
We believe investors should watch earnings-per-share (EPS) growth in the S&P 500 Index. Will companies achieve 10% EPS growth, as expected in current top-down estimates? EPS forecasts are often prone to change, but we worry that if earnings falter next year – particularly for high-growth stocks – there is little to no valuation support.