What’s Under the Hood? A Brief Guide to the 2019 Market
Here’s what happened:
The market – nearly every part of it – ripped higher in 2019. It was an awesome year.
Here’s what is important:
Valuation expansion drove nearly all of it, 92% to be precise.
Here’s the explanation:
Before we move any further, lets discuss a crucial concept. Where can investment returns come from?
1. Yield – Dividends and interest. Easy to quantify and directly related to the fundamental make up of companies you own. (Dividends are not guaranteed and are based on the discretion of the issuer).
2. Growth – Earnings growth. Harder to quantify, but directly related to the fundamental make of companies you own.
3. Valuation Change – The hardest to quantify, and directly related to the EXPECTATIONS of the companies you own…not the fundamental make up.
Now to the fun part – Apple Stock – (Ticker: AAPL):
The largest company in the world returned investors 89% for 2019! Apple alone, was responsible for nearly 10% of the S&P 500’s 31% return on the year. That’s incredible! (Past performance is not an indication of future results).
Percentages are one thing, now think about that in dollar amounts. Apple closed 2018 with a market cap (overall company value) of $693 Billion. It closed 2019 with a market cap over $1.35 Trillion – yes, that’s trillion with a “T”.
The driver of those returns, to propel a company by over $600 Billion in market cap, has to be some incredible developments and growth at Apple, right? Wrong.
Data below is from FactSet and refers to trailing 1-year numbers at the end of Apple’s fiscal year, which is in September:
- Sales growth must have been amazing. Actually, it was negative, down 2.20%.
- If it wasn’t top line growth, surely it was earnings. Actually, they were negative, down 7.20%.
- EBIT, EBITDA, and Free Cash Flow all had negative growth rates, the only positive growth rate was in the dividend
There seems to be a disconnect. How could Apple’s stock price go up, and go up that much, with things at the company level appearing stagnant?
Returns last year were generated more from things that have nothing to do with underlying fundamentals. As a reference, earnings growth has been the primary driver of stock returns since 2009, accounting for 67% of the S&P’s return vs only 8% in 2019. Why?
We won’t pretend to know the full answer, but here’s our guess: Look at investor’s opportunity set: stocks or bonds.
Currently, the forward earnings yield of the S&P 500 sits at 5.3%. That’s simply the aggregate earnings of the S&P 500 relative to its price, meaning 5 cents of every dollar in the index translates to net income.
The current yield on the 10-year Treasury bond, a symbol of security being backed by our government, sits at 1.79%. That means the S&P 500 has earnings yield 3.51% higher than a 10-year Treasury bond’s yield. Here’s the kicker, not only do stocks have a much higher yield relative to treasuries, they also give us, as investors, potential for growth.
We believe valuation change’s contribution to return has more to do with the opportunity set investors are stuck with than anything else. 2019 saw three rate cuts by the Federal Reserve and the equity market rose after each. As long as stocks look more attractive than bonds, valuations can continue to rise and further disconnect from fundamentals.
Here’s the good news:
The economy is rocking along. Economic health appears healthy enough. In addition, valuations are expensive in stocks, just not all that expensive when compare to bonds.
If you have any additional questions or want to talk with an advisor, please don’t hesitate to reach out with any questions!