Just after the midpoint of 2019, on July 10, the S&P 500 Index reached 3,000 for the first time. It has risen since then. As the market continues to reach new highs, fear among investors has also increased. Without a doubt, worries have been justified. Many people are concerned about China's slowing economy and its impact on global economic growth. Also, nearly two years after the start of the U.S.– China trade conflict, we have yet to see a meaningful resolution and we are not likely to see one any time soon. The uncertainty surrounding this issue was the cause of much of the market's volatility throughout 2019.
A look across global markets features a host of additional uncertainties, such as the seemingly endless challenges of Brexit, Italian debt, and anemic growth in Europe overall. Headlines have also focused on the implications of an inverted yield curve and the potential consequences of the 2020 U.S. presidential election. What has received much less attention are the factors that could drive equity markets meaningfully higher from here. These positive factors are also numerous, and they are why the S&P 500 Index has the potential to reach 5,000 in the next three to five years.
"In March 2009, the S&P 500 Index bottomed at 666. It would be quite impressive if 15 years later it reached 5,000."
The case for a further climb: Valuation
Many market observers believe equities today are overly priced and therefore are not a risk worth taking given their limited upside potential. The reality is that price/earnings multiples are in line with their average in recent decades. From 1991 to 2007, with the exception of two months, the trailing P/E for the S&P 500 never dipped below 16x. Assuming fourth-quarter estimates are correct, the market is currently trading at 19x 2019 earnings. By these measures, the U.S. stock market valuation seems decidedly average, without much downside from multiple compression.
On the flipside, there is a reasonable case to be made that P/E multiples will expand from current levels. This could be fueled by historically low long-term bond yields. In fact, for much of the second half of 2019, the dividend yield on the S&P 500 was higher than the 10-year U.S. Treasury yield. Also, the earnings yield of stocks has been higher than the 10-year bond yield since the turn of the century. The difference between them has been near an extreme recently, which makes equities arguably undervalued. When comparing stocks with bonds, stocks have almost never been cheaper.
What will drive the market now?What might prevent multiple expansion? One issue is concern about economic growth and how a slowdown, or even a recession, might lead to downward earnings revisions. However, stock market valuations could move higher in an environment where some pressures are alleviated — a trade deal with China coupled with a slight acceleration in global growth, for example.
Not all segments of the market would necessarily see valuations expand. High-quality companies with durable profit streams and dividends have been strong performers and have benefited via multiple expansion from low interest rates. This "bond proxy" cohort is expensive versus history and the valuations would likely contract, with prices falling in the event that bond yields were to rise.
Obviously, growth stocks, and technology stocks in particular, have powered the market over the past five years. Yet, in our view, valuations for many of the large- and mega-cap technology stocks remain attractive. Examples include Facebook, Alphabet (Google), Cisco, Intel, and Apple, which have undemanding valuations and a combined market cap of more than $3 trillion. At the same time, a number of undervalued sectors, such as financials, energy, and basic materials, which together account for 20% of the S&P 500, are priced well below historical averages and could help drive equity market gains in the years ahead.
What happens if a recession hits?Earnings growth is another element that could help power the S&P to that 5,000 milestone. As an example, if we saw annual earnings growth of 8.5% — which is below the 100-year long-term average — and the market's multiple expanded slightly to just over 20x (20.3x), the S&P 500 would reach 5,000 in five years. What can fuel this type of earnings growth? A reacceleration of global growth and a weakening dollar could be tailwinds, while modestly rising interest rates could boost earnings in sectors such as financials and energy.
Resilient earnings growth and multiple expansion could power the S&P to that 5,000 milestone.
Combining resilient earnings growth and multiple expansion could get the market to 5,000 even faster. With earnings growth of 8.5% per year and a 26x P/E multiple, the market would surpass that mark inside of three years. This is hardly the base case, but it's also not an extreme scenario in the event bond yields remain depressed.
What happens if we add a recession to the equation? It all depends on the timing. A recession late in our five-year time frame — say, in year four — might delay the 5,000 milestone. However, if a recession arrives in 2020 or 2021, we could still see a rebound and reach that 5,000 target within five years.
Due to the nature of equity performance, the road to 5,000 — a gain of almost 60% from recent levels — will certainly include periods of nervousness, downturns, rebounds, and rallies. But it is important to keep the long view in mind, especially to take advantage of periods of inevitable volatility.
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