To say that the stock market has some big shoes to fill in 2020 would be quite the understatement. In 2019, the benchmark S&P 500 (^GSPC 0.10%) gained approximately 29% (approximately 32% after adding dividends), which is more than four times higher than its historic annual average return of 7%, which includes dividend reinvestment and adjustments for inflation. Patient, long-term investors were handsomely rewarded.
But at the same time, worries continue to manifest about the potential for a U.S. or global recession. We're in the midst of the longest economic expansion in U.S. history, suggesting we're more likely to be in the late innings of this expansion than the middle.
We also witnessed a brief yield-curve inversion of the 2-year and 10-year U.S. Treasury note in late August, which is often indicative of an upcoming recession. And overseas, we're liable to see Brexit finally take place, which could put stress on an already slow-growing European market.
America's hidden recession is in plain view
Yet none of these factors guarantees a U.S. or global recession. There is, however, one indicator that's already pushed into recession territory and is the real story that investors should be discussing.
According to the latest "Earnings Insight" report from FactSet Research Systems on S&P 500 companies, fourth-quarter earnings for the benchmark index are expected to have declined by 2% from the prior-year period. This follows year-over-year (YOY) earnings per share (EPS) declines in Q1, Q2, and Q3, and would mark the first time that the S&P 500 has delivered four consecutive quarters of YOY EPS declines since Q3 2015 through Q2 2016. Since a "recession" is officially defined as two consecutive quarters of GDP contraction, four consecutive quarters of YOY earnings contraction certainly fits the bill.
Existing YOY EPS estimates suggest that 6 out of the 11 sectors of the S&P 500 will have delivered some degree of earnings contraction during the fourth quarter. This weakness is particularly noticeable with the energy, consumer discretionary, and materials sectors, which are expected to see earnings growth slow by 36.8%, 13.5%, and 10.4%, respectively. Within the energy sector, 4 of 6 sub-industries should see earnings decline by at least 20%, led by oil and gas drilling (minus 75%) and oil and gas refining and marketing (minus 51%).
On the flip side, just one S&P 500 sector is expected to deliver double-digit earnings growth: Utilities.
Ignore this data at your own risk
What makes these YOY declines in EPS even more egregious is the fact that S&P Global Market Intelligence predicted midyear in 2019 that S&P 500 share buybacks were on track to surpass the record of $806.4 billion in buybacks undertaken in 2018. S&P Global estimated that S&P 500 buybacks would be around $1 trillion in 2019. With fewer shares outstanding, this should provide a notable lift to EPS. But even with this benefit, EPS is declining. That's worrisome.
Furthermore, the last time investors witnessed a four-quarter stretch of earnings stagnation in the S&P 500, the benchmark index underwent two corrections and essentially remained flat on a YOY basis. That hasn't happened this go-around, with the S&P 500 advancing by more than 30% over the past 12.5 months.
The last time earnings stagnated, the S&P 500's Shiller P/E ratio (i.e., the price-to-earnings ratio based on average inflation-adjusted earnings from the previous 10 years) hovered around 24 to 25, which was higher than its historic average but well within its norms of the past 25 years. Over the past year, the Shiller P/E ratio has expanded to nearly 32, which is its third-highest reading ever and is outpaced only by the dot-com bubble and Q3 2018, right before the benchmark S&P 500 dove steeply in the fourth quarter of 2018.
With the understanding that recessions and stock market corrections are both inevitable and natural parts of the economic cycle, the conditions would appear to be ripe for a notable pullback in equities.
How to protect yourself from an "earnings recession"
What does this all mean for long-term investors? Surprisingly, not a whole lot. That's because, no matter how steep a correction has been thrown at the market over its long-tenured history, high-quality businesses tend to increase in value over the long run.
However, being a bit pickier about your stock-selecting process and focusing on dividend stocks wouldn't be a bad idea to help hedge against any short-term pain that might scare you into making a rash move that you'd regret later.
With regard to researching new companies to invest in, pay close attention to bottom-line growth and ensure that it's not being driven solely by share buybacks. Look for businesses that are continuing to expand their market share and offer competitive advantages.
For example, payment-processing facilitator Visa (V -0.47%) has been consistently growing its revenue in the low double digits every year, with EPS growth regularly topping sales growth. Visa is the runaway leader in U.S. payment-processing market share by network purchase volume, and earlier this week, it announced the $5.3 billion acquisition of fintech start-up Plaid. No matter what's thrown Visa's way, the company just keeps growing, making it a solid business to own a piece of, even with the various concerns I described above.
Similarly, dividend stocks are typically profitable and time-tested businesses designed to weather inevitable downdrafts in the economy. If you buy into a company like Johnson & Johnson (JNJ 0.23%), you're getting access to a healthcare conglomerate that's raised its payout for 57 consecutive years and is paying a market-topping 2.6% yield.
More importantly, Johnson & Johnson bears a AAA credit rating from Standard & Poor's, which is a higher rating than the U.S. federal government, and operates in a sector that's highly recession resistant. After all, we don't get to choose when we get sick or what ailment(s) we develop. These factors, along with Johnson & Johnson's diverse trio of operating segments, have ensured 35 straight years of adjusted operating earnings growth.
The point is to have your eyes open and be picky, but stay the course in companies that meet the criteria you're looking for.