Stock gains have lapped corporate profit growth during the roaring 2019 rally, but few portfolio managers are entering the new year concerned about investor exuberance.
The S&P 500’s 29% rise for the year, on track for the best showing since 2013, stands out in part because corporate earnings have advanced this year at a modest half-a-percentage-point clip. Rising earnings are typically the most dependable fuel for sustained stock-price gains, so the sight of major indexes climbing to records while profits shuffle behind often stokes concern about the risks of runaway sentiment, as seen in the 2000 dot-com bust.
But few market participants are worried about a stock bubble this time around. Many are reassured because the 2019 stock surge accompanied a Federal Reserve easing cycle that cooled fears of an imminent recession, widely seen as the biggest risk to share prices. Others contend that the year’s profit-stock disconnect is largely an accident of timing and that applying a longer time span to the comparison provides better context. Valuations, while not a bargain, appear reasonable at a time when trade tensions are cooling and economic fundamentals appear more solid than they have in some time.
Steve Chiavarone, a portfolio manager at Federated Investors, says the profit math looks downright reassuring for stocks if you go back an extra year beyond the standard year-over-year comparison. The S&P 500 has risen nearly 21% since December 2017—a period of which profits rose 25%, due largely to the late 2017 corporate tax cut.
In this view, stocks have more room to rise without triggering the valuation concerns that often arise when a rally is driven by what Wall Streeters call “multiple expansion”—rises in the price/earnings ratio that can obscure softening earnings growth.
“Don’t be fooled,” said Mr. Chiavarone. “The market hasn’t gotten the multiple response you’d expect with that because everyone was concerned about a recession or trade.”
Individual sectors show a similar picture. Multiple expansion mostly drove gains in shares of communications, technology, consumer staples and utilities —making it seem, at first glance, that those corners of the market might have overheated this year. But over the last two years, data showed earnings growth outpaced multiple expansion across all 11 sectors. And valuations fell for some of those sectors over that time, including communications and financial stocks.
That leaves the stock market roughly where it was in December 2017, trading at 18 times its earnings, a level analysts say isn’t obviously cheap or expensive. Short of a sustained flare-up in trade tensions, analysts and investors say conditions have ripened for stocks to notch back-to-back years of gains, although many firms’ expectations are muted for 2020.
Right now, analysts across Wall Street predict corporate profits will grow by 10% next year, according to FactSet. Although earnings estimates tend to be revised, and forecasts have come down in recent months, analysts said projections likely don’t factor in the U.S.’s recent decision to cut tariffs on some Chinese imports, which could provide some room for gains.
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Goldman Sachs analysts predict the S&P 500 will gain 5.5% next year, basing the forecast largely on a pickup in profit growth. Bank of America is more bearish, projecting a 2.4% gain for the index, also due mostly to profits.
BMO Capital Markets also predicts a 5.5% gain from the S&P 500’s current level.
“Earnings growth appears to be approaching a trough, and given the widespread negativity, is more likely to surprise to the upside than not,” BMO analysts said.
At the same time, stocks look more attractive against other assets, especially with sentiments on the economy improving, analysts added. And the Fed’s decision to cut interest rates this year, along with a broader bond rally, have pushed Treasury yields lower, justifying higher valuations, Mr. Chiavarone said.
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The yield on the 10-year U.S. Treasury note, for example, was recently at 1.934%, right about the same level as the dividend yield on the S&P 500. That could help reverse the flow of money away from bonds and money-market funds and back into riskier assets like stocks.
A Bank of America survey of nearly 200 fund managers who managed $627 billion in assets showed positions in stocks rose to their highest level of the year this month. That coincided with investors expecting a pickup in profits over the next 12 months for the first time since August 2018.
“It’s a pretty decent backdrop for risk assets right now,” said Thomas Hainlin, global investment strategist at U.S. Bank Wealth Management. “We’re not looking at a nearly 30% return on the S&P like we got this year. But we expect lower returns and have a positive outlook for 2020.”
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Write to Michael Wursthorn at Michael.Wursthorn@wsj.com
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