In 2019, a strong US consumer and housing market supported the US economy despite the headwind of tariffs and trade tensions. The manufacturing sector however, contracted in 2019 in the United States and other countries around the world as measured by purchasing managers’ indices. Our team is closely monitoring the US manufacturing sector for signs of an inflection point. Why? Manufacturing comprises approximately 30% of the broader US economy while goods producing firms make up nearly 45% of S&P 500 market capitalization and 40% of revenue. To extend that, we would argue there are many more companies that are derivatives of manufacturing. For example, a company may be classified as providing a service, but is dependent on manufacturing. For example, Amazon provides a service but is connected to manufacturing in providing that service. Because of this, there has been an historical relationship whereby the health of the manufacturing sector leads S&P 500 earnings. Last year’s weak US manufacturing sector was a contributor to earnings weakness for the S&P 500 Index that saw earnings shrink by a percent and a half in 2019 after growing 24 percent the prior year.
There are several manufacturing measures that we follow but we pay very close attention to a proprietary index that we created many years ago that we call the Nuts & Bolts Index. The Nuts & Bolts Index illustrates the Z-score of the major manufacturing districts in the United States. (Nerd Talk: the Z-score measures how many standard deviations below or above the population mean. Said simplistically, it gives you an idea of how far from the average the current growth rate is.) Our work suggests that the Nuts & Bolts Index leads S&P 500 earnings by approximately three to six months with a correlation of nearly 75%. The Nuts & Bolts Index has continued to trend downwards, indicating that S&P 500 earnings will be flat to negative throughout the first half of the year. An infliction in manufacturing activity would be encouraging for S&P 500 earnings growth moving forward.
“It's the nuts and bolts time of the year and we don't have enough nuts and bolts.”
— Darryl Sutter
You don’t necessarily need positive earnings growth for positive index returns on a calendar year basis but gains without earnings leads to a pricier index. The S&P 500 index ended the year priced at 21.6x trailing earnings as the index returned nearly 29% in USD (price return) in a flat earnings environment. While this trend may continue, it is rare. The last time that the index had two consecutive years of positive returns driven solely on multiple expansion was in 1985 and 1986. It is unlikely that valuations will do the heavy lifting alone for returns this year and will therefore need to be supported by earnings growth. Equity markets are forward pricing and therefore the likely theme for 2020 is show me, since most of last year’s returns were driven by the expectation of a recovering global economy and strong earnings growth. We will be watching US manufacturing very closely in the coming months to see whether those expectations will be met in 2020.
Macan Nia, CFA
Senior Investment Strategist
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