Lowering EPS Estimates but Valuations Remain Healthy

The market hit our 2019 target of SPX 3110 this week and this inspired us to review our price targets, earnings and assumptions for 2019 and 2020. With third quarter earnings results for the SP500 now 90% complete, our second half EPS estimates appear high. Bringing our third and fourth quarter estimates more in line with the S&P Dow Jones consensus benchmark, our calendar 2019 earnings forecast falls from $167 to $160 and our 2020 earnings estimate for the SP500 eases slightly from $186 to $184.

Next, we put our new estimates into our valuation model which is stress-tested for 2020 inflation of 2.6% and a 10-year Treasury bond yield of 3.8%. Despite newly lowered earnings estimates and inflation and interest rates well above our expectations, our valuation model suggests an SPX 2020 range of SPX 2800 to 3450. We prefer to remain on the conservative side and are initiating a new 2020 SPX target of 3300. Should a trade agreement materialize in the next six months, this target would likely be revised. See page 11.

It is worth pointing out that the SPX has been hugging the upper end of our model’s projected fair value range since late 2016. This does not surprise us since an environment of low and steady inflation supports a higher PE multiple. Assuming inflation remains benign, one could expect the SPX to continue to trade in the upper half of the fair value range. The top of this range in late 2020 implies a move to SPX 3450.

Conversely, if the UK fails to solve its Brexit issues, if impeachment investigations wear on investor sentiment, or if unexpected events shock the market, our model suggests equities have substantial valuation support at the SPX 2800 in 2020.

Quarterly EPS Results

IBES Refinitiv is currently forecasting third quarter SP500 earnings to decline 0.4%. However, excluding the energy sector, the earnings growth estimate increases to 2.2%. Of the 461 companies in the SP500 that have reported earnings to date for 3Q19, 74.6% have reported earnings above analyst estimates and 18% missed estimates. This is comfortably above the long-term average of 64.8% and the average of 74.1% seen in the prior four quarters. In a typical quarter, 65% of companies beat estimates and 20% miss estimates. Third quarter revenue is expected to increase 3.8% from a year ago and excluding the energy sector, the revenue growth estimate rises to 5.2%. The healthcare and utilities sectors have the highest earnings growth rates for the quarter at 9.4% and 6.7%, respectively; and the energy sector has the weakest anticipated growth rate at negative 37.8%. Third quarter earnings comparisons for energy help to explain the sector’s underperformance in 2019. However, the good earnings performance by both healthcare and utilities make their price performance less understandable. Both sectors rank just above energy on a year-to-date basis. See page 16.

Economic Reports Support a Dovish Fed

A medley of data was reported this week on retail sales, inflation and trade and overall, it supports a dovish Fed, in our view. Retail sales rebounded modestly in October after falling in September. More specifically, sales rose 0.3% after declining 0.3% the previous month. On a year-over-year basis, total retail sales rose 3.1% In October versus a 4.1% gain in September; however, October sales could have been hurt by Hurricane Dorian, weak iPhone sales and the General Motors (GM – $36.38) strike. October’s sales, excluding motor vehicles, rose 2.8% YOY. See page 3. On the whole, this report was neutral in our view.

The US-China trade conflict has been a major topic of concern for investors, yet it has only made a small dent in the total US trade. The trade deficit is running at an annualized $862.7 billion as of September versus $874.8 billion in 2018. Department of Commerce data shows the trade deficit is currently at an estimated 4% of current GDP, while the Census BOP basis, shows the 12-month running ratio to be 3.1% of GDP. Merchandise trade data is available on both custom-based trade statistics and on a balance of payments (BOP) basis. Note that data on services is only available on a BOP basis, which means the real trade deficit is apt to be closer to the BOP 3.1% of GDP which includes services. See page 4.

While headline trade numbers have not changed dramatically, trade is changing beneath the surface. China is no longer our top trading partner and as of September 2019 fell to third place behind Mexico and Canada. Nevertheless, China continues to have the largest trade deficit with the US at $263 billion year-to-date, which is 3 ½ times larger than Mexico which ranks second with a $76 billion deficit. Ironically, the trading partner with the largest surplus with the US is Hong Kong at $20.3 billion. See page 5.

The inflation backdrop is favorable for monetary policy. PPI final demand prices rose 1.0% YOY in October, while intermediate processed goods prices fell 3.7% YOY. CPI rose a benign 1.8% YOY in October however core CPI rose 2.3% YOY. The rise in core prices was due primarily to services. See page 6. The trade war has not generated the rise in consumer prices most economists predicted for 2019. In fact, import prices, excluding petroleum products, fell 1.5% YOY. The effective fed funds rate of 1.55% is comfortably above September’s PCE index of 1.3% YOY. See page 7.

But we remain bothered by the pace of inflation seen in the medical care sector where prices rose 4.3% YOY in October. All components of healthcare rose, but the 20.1% YOY jump in health insurance is most disturbing. See page 8. This could be a cyclical pricing cycle for insurers, or it could be in anticipation of a new rule requiring more transparency in hospital and insurance pricing. In a new executive order, the Trump administration is requiring hospitals to disclose for the first time the prices they negotiated with health insurers for a wide range of services, as well as the prices they charge patients who are paying with their own money. Hospitals will also be asked to create a list of 300 so-called “shoppable” services that patients can use, targeted to more elective services where customers could have the opportunity to shop around. The Trump administration is hoping a little bit of sunlight could help disinfect the high costs of US healthcare.

Technicals Continue to Support Equities

The technical scoreboard has not changed much in the last week, although the NYSE cumulative advance decline line made a new high on November 15 which now confirms the ongoing advance in the popular indices. The Russell 2000 index continues to lag behind the popular indices, but like last week, it is close, but has not yet broken above the top of its recent trading band of 1450-1600. A breakout would be bullish. An uptrend line that has supported the DJIA since the 2016 low was recently tested successfully and this strengthens the longer-term bullish trend. See page 12. The 25-day up/down volume oscillator is 1.76 and neutral after being in overbought territory for five of six trading sessions last week. This was the fifth consecutive overbought reading of 2019 and it followed an overbought condition that lasted for eight of ten trading sessions between September 10 and September 23. Consecutive overbought readings denote steady buying pressure and only appear in a bull market cycle. In sum, this is a positive sequence in this indicator.

Regulation AC Analyst Certification

I, Gail Dudack, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly related to the specific views contained in this report.




“Overweight”: Overweight relative to S&P Index weighting

“Neutral”: Neutral relative to S&P Index weighting

“Underweight”: Underweight relative to S&P Index weighting

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