The S&P 500 fell 10% from July as interest rates surged. The 10-year Treasury yield topped 5%, a level last seen in 2007.
With stocks now cheaper, are we about to see a “Santa Claus Rally” as we head into historically great months? We look at that in this memo.
Rebound Brings S&P 500 Back Into Key Price Channel
Developments in the S&P 500 price action were noteworthy this week:
- Price rebounded off the 4,100-4,200 level, an important trading range of recent months
- It’s now back into a key price channel that captured the rally since the October 2022 lows
- Key downtrend line will likely be tested in coming days
While recent developments are bullish, stocks still face considerable headwinds in the months ahead. We delve into those next.
Stocks are Priced to Perfection
Stocks remain fundamentally unattractive headed into what we expect will be a recession by the 1st-half of 2024.
The S&P 500 still faces 2 key risks:
- Valuations are expensive
- Concentration risk is high (i.e., undiversified bet)
The Magnificent 7, a group of superstar stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla), reflects these concerns the best:
- Valuations: Their forward earnings yield (i.e., inverse of forward P/E ratio) at 4% is significantly lower than the 5.5% we could earn risk-free with T-Bills. Why would you take the risk?
- Concentration: They’ve increasingly accounted for a bigger share of S&P 500 returns, making the bet less diversified
Stocks are so expensive that even those beating Q3 earnings estimates are getting sold:
- Good earnings saw bad market reactions: 1% drops in the 2 days following the earnings report, compared to a 1% gain on average
- Bad earnings saw very bad market reactions: companies that missed earnings dropped by 5%
We said that stocks were “priced to perfection” back in June. Good earnings were already priced in by optimistic investors.
We don’t expect a big rebound in earnings in coming quarters given the weak state of the housing market.
Investors are Pessimistic, a Bullish Signal in the Short-Term
Market sentiment should be a big part of your investor toolkit. When sentiment is heavily-tilted to bearish, the odds are more favorable that the market moves higher next, and vice versa.
The recent selloff in stocks has turned individual investors very pessimistic. The AAII indicator turned even more pessimistic since the video for this article was filmed, as reflected in the chart below.
When sentiment is bearish like today, a lot of the risks are already priced in.
The S&P 500 tends to see better-than-usual returns in November and December (year-end rally).
We found that when bearish sentiment is elevated in October, year-end rallies are even stronger (2x better).
A couple of things you should know about year-end seasonality:
- It’s just a pattern and not a guarantee that stocks will rally
- There’s debate as to what exactly causes it
What Could Drive a Year-End Rally in Stocks?
Two outcomes could propel stocks higher through year-end:
- Weakening economic data (i.e., bad news = good news)
- Decelerating inflation
Stocks rallied this week on the back of weakening economic data reported for October:
- Big declines ISM PMIs (both manufacturing and services)
- Weak job growth
Weakening economic data isn’t a good thing, it suggests we’re heading into a slowdown. But financial markets aren’t always rational.
Historically, when the Fed stops hiking rates because of weak data, it actually triggers a rally. What’s what we’re seeing today. That could continue until a recession actually starts.
The fact that inflation is showing real signs of slowing also means that investors can actually get optimistic about a Fed pause.
The 3-month annualized rate of core PCE inflation, the Fed’s preferred measure, is close to the 2% target. Investors may interpret this as mission accomplished by the Fed.
Conclusion: Recession Remains the Endgame, But Short-Term Rally is Possible
Weak economic data combined with lower inflation could make investors bid stock market valuations higher.
Do we think that’s justified? No. Does the market care what we think? Also no.
The last 15 years has been a story of analysts getting more and more optimistic. Even more recently with soaring inflation, interest rates and recession risks.
Eventually, we think a recession will end that optimism. The steepening of the yield curve points to that being imminent.
We also happen to think the slowdown will be worse than most think:
- The deeper the yield curve inversion, the deeper the slowdown
- The depth of the current inversion implies a worse than average downturn
That means the risk-reward for stocks doesn’t look good, especially if valuations continue to rise into year-end.
Even if the Fed cuts, that would most likely mean the economy is in free fall.
After yield curve inversions, unemployment typically rises which negatively impacts stocks:
- Jobless claims have held up better than expected because employers are hoarding labor.
- We expect that will change as businesses accept the reality of a deep recession.
