Clients of the Firm,

After a very strong year in 2019 for markets, it is appropriate to take stock of where we are as investors and what is likely, unlikely and possible in the year to come.  As intelligent investors, we should examine valuation levels from both an absolute and relative perspective in order to craft a strategy that makes sense for the year ahead.

The year 2019 saw great strength in markets, a stark contrast from the rapid decline that took place a year ago in the 4th quarter of 2018. Indeed the S&P 500 finished the year at 3,230 near all-time highs.  This rally occurred largely because three key fears of late last year did not come to pass: a recession in 2019, an aggressive hawkish Fed, and an escalated trade war with China. 

US Economy

The U.S. economy continued to grow in 2019 with GDP likely to exceed 2.4%, according to consensus estimates, with very low inflation.  U.S. employment continued to strengthen throughout the year as unemployment rates reached their lowest levels in post-war history.  This economic strength resulted in a small earnings expansion for the S&P 500 rather than the earnings recession many feared a year ago.  As we have written many times before, earnings (or per share profits) and the multiple investors are willing to pay for those profits ultimately drive stock market performance. 

The Fed

The Fed shifted its policy from rate hikes to rate cuts in 2019.   This action took pressure off of credit markets as well as made the opportunity cost of investing in equities versus bonds much more compelling.  The Fed cut rates by 0.75% in 2019 and ended the year on hold.  In addition, the Fed indicated they are not likely to cut or raise rates in the near-term and will wait to see how inflation, employment and economic data play out.  Lower interest rates tend to increase the multiple of earnings investors are willing to pay as the relative return of stocks exceeds the risk-free rate of bonds by a greater margin.

China Trade

Finally, in mid-December a phase one trade deal between the U.S. and China was reached and is expected to be signed on Jan 15, 2020.  This trade deal reduced tensions with the Chinese and resulted in the halting of new trade tariffs that were expected to be imposed in December of 2019. The absence of new trade barriers was viewed by markets as a great relief and largely fueled the rally in the 4th quarter of 2019.      

2020 Outlook

As we look forward to 2020, we can analyze the relative valuation of the equity market as a guide for what to expect.   Earnings for the S&P 500 are expected to be $178.21(according to Factset) for 2020. This estimate is a roughly +9.50% increase from projected 2019 earnings.  With the stock market closing the year near record highs, the trailing P/E of the market is 19.81 times and the forward P/E is 18.03 times.  These levels are at the high end of a normal range of market values, but not near the extremely high valuations seen in stock market bubbles of the past. 

Suppressed interest rates are likely to remain throughout 2020 and thus more elevated P/E levels are likely to persist.  If earnings come in as expected, the range of reasonable valuations for the S&P 500 in 2020 is likely to be between 3,565 and 2,852.  Clearly, earnings will need to achieve the robust expectations that market participants have for them in 2020 to see meaningful upside beyond the 10% we see as our upside target.  Our downside target of 2,852 which is roughly 11% below current levels indicates a 20% top to bottom range for 2020 with risks roughly equal to the upside and downside.

Risks to P/E ratios include Middle East conflict with Iran, Brexit and the uncertainty and extreme polarity of the upcoming 2020 U.S. election.  We expect these and other uncertainties to persist throughout the year and that P/E levels, a measure of market sentiment, will fluctuate to react to incoming data and news on these fronts.  Therefore, even as we see a potential +10% upside to markets, we expect to see more volatility than we saw in 2019.   Politics, policy and power shifts in 2020 may have an amplified impact on markets as different political choices may have radically different outcomes on various sectors of the market.

This likelihood leads us to a strategy for 2020 which revolves around maintaining our client equity allocations at current levels and using hedging where appropriate to dampen downside risk, manage tax liability and to protect gains.  In addition, we feel that remaining on the shorter end of the maturity curve for bonds continues to be appropriate given the very limited spread one is paid for taking more time risk on fixed-income.   This strategy should help clients weather the likely volatility ahead, while still participating to the upside if best case scenarios on earnings and multiples play out.           

After a good year in 2019, we can expect to see less linear upside movement in 2020.  For the reasons stated above, our preferred strategy based on current market conditions is to remain invested in equities and short-term bonds vs. cash.   Hedging tools or higher short-term bond positions can allow us to damp volatility and protect us against unexpected negative outcomes that would either impact earnings or market sentiment, the two key drivers of stock market valuation.

As our firm continues to grow, now exceeding $100 million in assets under management, we are so grateful for the 16 years of support you have given us. Managing money is difficult work and requires discipline and a constant vigilance to the drivers of the economy, earnings and the companies we invest in.  We take that job seriously and appreciate the trust and support you place in us in the management of your funds.  Thank you and Happy New Year!

Sincerely,

Peter C. Wernau

CEO, Wernau Asset Management

Important Legal Disclosure

This letter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Wernau Asset Management, Inc. ("Wernau Asset Management) is a registered investment adviser with its principal place of business in the Commonwealth of Massachusetts. Wernau Asset Management and its representatives are in compliance with the current registration requirements imposed upon registered investment advisers by those states in which Wernau Asset Management maintains clients. Wernau Asset Management may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration requirements. This letter is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Wernau Asset Management with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Wernau Asset Management, please contact Wernau Asset Management or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Wernau Asset Management, including fees and services, send for our disclosure statement as set forth on Form ADV from Wernau Asset Management using the contact information herein. Please read the disclosure statement carefully before you invest or send money.