Could 2018 Bring Another 20% in US Stocks Returns?

Will the S&P follow its surprise breakout 2017 performance with another year of 20+% returns?

January 30, 2018

Formulating a year-ahead outlook for multi-asset class returns is a lot like tracking winter storms. Any number of factors must be taken into account in determining the confidence bands that frame the ultimate path of the system. Most of the time it pays to be conservative. But there are also times when it is important not to let one’s natural skepticism obscure the potential upside.

According to QMA, 2018 shapes up to be one those years. After a 2017 that saw the S&P 500 Index return 22%, consensus forecasts have called for lowering expectations for 2018. QMA’s outlook falls roughly in line with those views. Its base case scenario, outlined in its 2018 Outlook & Review PDF opens in a new window “Goldilocks Growth and the Missing Bears,” is for equities to once again soundly outpace bonds, but with S&P returns more in the range of 10% for the year. However, as QMA breaks down the numbers, what quickly becomes apparent is how few pieces would need to fall into place for the S&P to follow its surprise breakout 2017 performance by dumping another 20+% of returns onto investors’ portfolios.

The Case for Near-20% Earnings Growth

In 2017, US corporate earnings grew by a robust 12%. QMA believes earnings growth has the potential to be even stronger in 2018.

When one aggregates sell-side research analysts’ bottom-up next-12-month earnings forecasts for the S&P 500, the result is a consensus projection of 11.2% earnings growth for 2018. Under most circumstances, this would suggest we are in line for a bit of a fallback. After all, the usual pattern is for growth estimates to start the year too optimistic and be revised downward as analysts incorporate new information about company profits. That is, analysts tend to be systematically biased toward optimism. But there are years, reasonably rare exceptions to the rule, where estimates stay steady (as was the case in 2017) or are revised upward. QMA’s quantitative work suggests there is momentum in analyst forecasts. Due to herding effects, net revisions to forecasts tend to predict future changes.

Consensus Earnings Estimates and Revisions for the S&P 500

 

Date

FY1 Estimates

FY2 Estimates

Implied Growth

01/13

-

-

8.3%

02/13

-

123.56

11.2%

03/13

-

123.21

11.4%

04/13

-

123.25

11.3%

05/13

-

122.18

11.0%

06/13

-

121.97

10.7%

07/13

-

122.07

10.7%

08/13

-

121.10

10.8%

09/13

-

121.09

10.8%

10/13

-

118.36

8.8%

11/13

-

118.40

8.8%

12/13

-

118.32

8.8%

01/14

-

118.32

8.8%

02/14

117.87

131.22

11.3%

03/14

117.91

131.27

11.3%

04/14

118.50

131.87

11.3%

05/14

118.58

131.87

11.2%

06/14

118.50

131.92

11.3%

07/14

118.47

132.66

12.0%

08/14

118.38

132.27

11.7%

09/14

117.43

131.77

12.2%

10/14

116.77

129.52

10.9%

11/14

117.44

128.92

9.8%

12/14

115.93

120.88

4.3%

01/15

115.94

120.90

4.3%

02/15

118.93

134.36

13.0%

03/15

118.82

133.96

12.7%

04/15

117.98

132.73

12.5%

05/15

118.43

132.70

12.1%

06/15

117.90

132.18

12.1%

07/15

118.37

131.45

11.0%

08/15

118.13

130.73

10.7%

09/15

117.27

127.88

9.0%

10/15

117.04

127.23

8.7%

11/15

117.24

126.56

7.9%

12/15

116.32

125.21

7.6%

01/16

116.16

123.18

6.0%

02/16

118.60

134.74

13.6%

03/16

118.65

134.79

13.6%

04/16

117.93

133.79

13.4%

05/16

117.44

133.42

13.6%

06/16

117.43

133.40

13.6%

07/16

117.47

132.87

13.1%

08/16

117.15

132.54

13.1%

09/16

116.86

131.46

12.5%

10/16

116.90

131.51

12.5%

11/16

117.44

130.91

11.5%

12/16

117.29

130.85

11.6%

01/17

117.52

130.46

11.0%

02/17

129.33

144.98

12.1%

03/17

129.04

144.77

12.2%

04/17

129.60

144.98

11.9%

05/17

129.81

144.96

11.7%

06/17

129.65

144.97

11.8%

07/17

129.66

144.14

11.2%

08/17

129.91

143.93

10.8%

09/17

129.33

143.57

11.0%

10/17

129.83

144.10

11.0%

11/17

129.92

144.26

11.0%

12/17

129.94

145.32

11.8%

As of 12/31. Source: QMA, FactSet.

This suggests current earnings growth estimates are not only solid, but may need to be revised upward even further. And, in QMA’s analysis, this is before incorporating the one-time boost to earnings growth the firm projects coming from the lower corporate tax rates encoded in the recent GOP tax overhaul, which could add another 5-7% on top of that.

Why Current High Multiples Could Go Even Higher

Of course, even if earnings grow by roughly 20%, as the above math suggests, stock prices could still rise much less if price-to-earnings (P/E) multiples contract. In 2017, multiples expanded from 17.2 to 18.6. The consensus view is that this is unsustainable for 2018. However, as QMA points out, earnings multiples typically expand rather than contract in late-cycle environments and typically fall only during economic downturns.

Average Changes in S&P 500 Multiples throughout the Cycle (1981-2017)

 

Cycle Period

Change in Multiples

Every Cycle (Year 1)

2.65

Mid-Cycle (Annualized)

0.85

Late Cycle (Final Year)

1.24

Ressectionary Fall (Cumilative)

-5.70

*Cycle defined from market peak to trough. As of 12/31/2017. Source: Standard & Poor’s, Thomson Financial, Haver Analytics®, Credit Suisse.

While one could make a case for multiple contraction as a consequence of the interest rate hikes expected from the US Federal Reserve in 2018, QMA’s own work suggests higher rates are actually supportive of P/E ratios as long as the tightening comes in response to continued healthy growth conditions and not an emerging inflation problem. So, absent a nasty inflation surprise, QMA thinks the odds are fairly good that multiples at least stay put.

Risks to the Downside – and Up

So, why isn’t QMA’s calling for 20% returns in its base case scenario? For the simple reason markets, like weather systems, rarely move in a straight line. Several important downside risks loom, from the aforementioned inflation surprise to a growth scare out of China to an escalation in Saudi-Iranian tensions that could spark a spike in oil prices. Any of these could adversely affect either the earnings or multiple side of the equation.

We should note, however, there are also upside risks. After years of anemic productivity growth, productivity surged 3% in Q3 2017 (the latest reported), the largest jump in four years. The reading could be a blip, or it could be a sign that Big Data, cloud computing, artificial intelligence, 3D printing, etc., are finally having a delayed impact on the real economy, as major waves of innovation often do.

The potential ripple effects of this are the chief reason why among its various scenarios QMA also finds there to be a reasonably good outside chance that S&P returns for the year top 20%.


Definitions

S&P 500 Index is an unmanaged index of 500 common stocks, weighted by market capitalization, representing approximately 75% of the New York Stock Exchange. The value-weighted index represents about 75% of the NYSE market capitalization and 30% of the NYSE issues.

Risks

High yield bonds, known as “junk bonds,” are subject to a high level of credit and market risk. U.S. government securities and U.S. Treasury bills are backed by the full faith and credit of the U.S. government, are less volatile than equity investments, and provide a guaranteed return of principal at maturity. All indexes are unmanaged. An investment cannot be made directly in an index. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. Past performance is no guarantee of future results.

Disclosure

The views expressed herein are those of QMA at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. This commentary does not purport to provide any legal, tax, or accounting advice. Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. Each manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.

This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation about managing or investing your retirement savings. Clients seeking information regarding their particular investment needs should contact a financial professional.

QMA is the primary business name of Quantitative Management Associates LLC, a wholly owned subsidiary of PGIM, Inc. (PGIM), a Prudential Financial company. © 2018 Prudential Financial, Inc. and its related entities. PGIM and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.

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