track level view of crisscrossing railroad rails

By Lori Calvasina

While U.S. equities have powered forward for more than a year, RBC Capital Markets, LLC’s Head of U.S. Equity Strategy Lori Calvasina tells us why the market should throttle back and deliver gains that hew closer to historical averages. She gives her thoughts on the U.S.’s vexing valuation, whether prospects are better in other markets, and where to find opportunities as shifts in the U.S. market play out.

Until just recently, the market methodically marched higher for months. How do you think the year will unfold?

Lori Calvasina: We expect 2020 to be a year of moderation, turbulence, and transition in the U.S. equity market. Risk of a near-term pullback is quite high, in our view, largely due to stretched valuations and euphoric positioning among institutional investors.

But down years are rare for the S&P 500 outside of periods associated with growth scares, recessions, or financial market bubbles. Those scenarios are still unlikely, and 2020 should be another up year for the market, just one that delivers returns closer to the long-term average and with greater volatility.

Our year-end 2020 S&P 500 target is 3,460, a full-year gain of 7.1 percent. This target assumes modest profit margin expansion, roughly four percent revenue growth, and six percent earnings growth ($174 per share) compared to 2019. We expect stock buyback and dividend activity to remain supportive of U.S. equities this year.

A proxy for market sentiment
Asset managers’ notional net long position for S&P futures (USD)
Asset managers’ notional net long position for S&P futures (USD) chart

Institutional investor positioning turned euphoric recently, making the stock market vulnerable to bad news.

Source - RBC Capital Markets U.S. Equity Strategy, RBC futures desk, Commodity Futures Trading Commission; data through 1/21/20

What could be the catalysts for a market pullback?

Potential catalysts include the realization by investors that U.S. economic growth is likely to be moderate rather than rapid, and reductions in corporate earnings forecasts.

We think coronavirus fears could contribute further to U.S. equity market volatility in the short term if they continue to build, since this poses a risk to the modest improvement in corporate optimism that has resulted from the completion of the Phase 1 trade deal with China. The bigger issue here is that investors could at least temporarily start to doubt the “hope trade” that has propelled U.S. equities higher since last fall. That market move was driven by the anticipation of a positive inflection in global economic conditions.

Additional geopolitical flare-ups could also challenge the market, whether between the U.S. and Iran or further drama in the trade conflict with China as Phase 2 negotiations get underway. We suspect the Phase 1 deal will not be substantive enough to restore the severe damage done to business confidence.

The U.S. election also has the potential to trip up the market. We think institutional investors have become too complacent by assuming outcomes that are positive for the market in both the primaries and general election. The Democratic primary season, which begins with the Iowa caucuses on Feb. 3, and will largely play out by the end of March, could rattle equity markets.

You describe the S&P’s valuation as “vexing”—why?

With the Fed cutting interest rates, 2019 was a year of significant valuation expansion for the S&P 500, which closed the year on a high of 19.8x forward earnings (based on consensus estimates from two fiscal years from now). We don’t expect much expansion in price-to-earnings ratios in 2020 nor any additional rate cuts, and we don’t view the Fed’s current balance sheet management efforts as quantitative easing. This supports our expectation that stock gains will be more modest in 2020.

RBC Capital Markets’ combo model points to a stretched S&P 500 valuation
RBC Capital Markets’ combo model points to a stretched S&P 500 valuation chart

S&P 500 12-month forward returns (RHS)

S&P 500 combo model Z-score (LHS)

The value of our combo model is at its highest of this bull market cycle, and is approaching the peak of 1999.

Note: The combo model uses 34 different measures, including various flavors of price-to-earnings, price-to-book, and price-to-cash flow

Source - RBC Capital Markets U.S. Equity Strategy, S&P Capital IQ/Clarifi estimates, Refinitiv I/B/E/S estimates; data through 1/24/20

One of our favorite ways to assess valuations for the S&P 500 is our “combo model.” It summarizes how the index’s valuation looks on 34 different measures, including various flavors of price-to-earnings, price-to-book, and price-to-cash flow. Based on this model, the S&P 500’s valuation is very stretched compared to its long-term average. Furthermore, such a valuation has historically been consistent with flat-to-low single-digit returns in the stock market over the subsequent 12 months.

The S&P 500’s stretched valuation adds to our suspicion that U.S. equities have already priced in any benefits of a Phase 1 trade deal with China, the same way that the market priced in the benefits of corporate tax cuts in Q4 2017 before they were implemented in January 2018.

With moderate returns expected in the U.S., are prospects better elsewhere?

We are starting to see opportunities in other markets. Valuation, economic trends, and Fed policy are key reasons. The U.S. market remains overvalued relative to most major regions. Positive surprises in domestic economic data have faded, but are returning for Europe and China. U.S. equities tend to outperform non-U.S. equities when the Fed is easing. Our economists think the Fed will pause in 2020 due to the resilience of the economy, de-escalation in the trade war with China, and the presidential election. That would remove one of the tailwinds for U.S. equity leadership.

Since the global financial crisis, the performance of the U.S. compared to other markets has been loosely tied to the performance of U.S. growth stocks (such as the Technology sector) versus value stocks (such as Financials and Industrials). Non-U.S. stock markets are less exposed to growth sectors and are more value-oriented. If the recent shift toward U.S. value stocks has staying power, non-U.S. stock markets could outperform the S&P 500.

Money has flowed out of U.S. equity funds recently, while Europe, Japan, and China have all seen inflows. After many meetings with institutional investors, we are left with the impression that global investors are more open to reallocating assets from the U.S. to non-U.S. than they have been in some time.

Trends in global large-cap equity funds’ regional allocations (% of holdings)
Trends in global large-cap equity funds’ regional allocations (% of holdings) chart

North America

Greater Europe

Greater Asia

Allocations to North America have surged while positions in Europe and Asia have retreated; these trends could begin to reverse.

Source - RBC Capital Markets U.S. Equity Strategy, Morningstar; data through Q3 2019

Where do you see the most attractive sector opportunities in the U.S.?

We continue to favor Financials and Industrials. Both sectors are deeply undervalued relative to the S&P 500, and they tend to outperform when the ISM Manufacturing New Orders Index is rising, and when value is beating growth. These sectors have seen a stabilization in exchange-traded fund flows recently.

We also have an ongoing Overweight in Utilities as an “insurance policy” for volatile periods. The sector has low policy risk regarding the presidential election, and it tends to outperform when the ISM Manufacturing New Orders Index is falling, which provides some protection should economic data disappoint. This is not our base-case forecast but could happen given we are in the late stage of the business cycle. The Utilities sector no longer looks overvalued versus the S&P 500.


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Lori Calvasina is a managing director and head of U.S. Equity Strategy at RBC Capital Markets, LLC. She focuses on positioning within the U.S. equity market in terms of size, style, sectors, and stocks. Calvasina has spent nearly two decades as an equity strategist at major investment banks, and the financial media, such as CNBC and Bloomberg, frequently taps her expertise of the U.S. stock market.