Will There Be A Santa Claus Rally This Year?

Going back 120 years, December has traditionally been a very good month for the stock market.  Within the last 120 years the S&P 500 has been positive in December 73% of the time.  The Russell 2000, which is the index for small cap stocks, has been up 87% of the time in December.   This boost in the final month of the year is known to traders as the “Santa Claus Rally”.  Should investors expect a Santa Claus rally in 2018 given the recent sell off in the markets?  The answer may hinge on the results of the Federal Reserve Meeting on December 19th. 

The Fed Decision

The fate of the Santa Claus rally may very well be in the hands of the Federal Reserve Committee this year.   The Committee’s decision regarding the Fed Fund Rate could either cause the market to rally if the Fed decides to keep rates unchanged or it could push the markets lower if they decide to move forward with the anticipated quarter point rate hike.   The Fed has a really tough decision to make this year.  The goal of the Fed is to keep interest rates at a level that promotes full employment and a target inflation rate of 2%.  In periods of economic expansion, it’s the Fed’s job to make sure the economy does not overheat which in turn could lead to prices of goods and services in the U.S. spiraling out of control.

Over the past few years, the U.S. economy has continued to expand and the Fed has been raising rates in quarter point increments.  A very slow pace by historic standards.   The Fed has already raised the Fed Funds Rate three times in 2018. What are the chances that the Fed raises rates again in December?

Solid Employment & Inflation In Check

The good news is there is not a lot of pressure for the Fed to raise rates in December.  As of October, the unemployment rate sits at 3.7% and the employment data that we have seen throughout November has been strong.  Historically, a strong job market usually results in higher wages for employees which is the main driver of inflation.  So in the current economic environment, the Fed’s main focus is keeping inflation within its 2% target range.  The Fed’s measuring stick for the rate of inflation is the Personal Consumption Expenditures Index.  Otherwise known as the “PCE”.

There is a “Headline PCE” and a “Core PCE”.  The Core PCE excludes prices for food and energy which is the Fed’s main barometer. Why does the Fed use Core PCE?  Food and Energy prices can fluctuate significantly over short periods of time which can distort the results of the PCE index.

Below is a chart of both the Headline PCE and the Core PCE:

As you can see in the chart, the blue line that represents the Core PCE is right below the Fed’s 2% target.  The PCE index is reported monthly and in October the PCE came in at a year-over-year change of 1.97%.  Also you will see in the chart, due to the drop in the price of oil over the past two months, the Headline PCE is also dropping.  While Headline PCE is not the Fed’s main measuring stick, there does seem to be a correlation between Headline PCE and Core PCE.  It makes sense because regardless of the price of the product that you are taking a sample of, that product needs to be transported from the producer to the end user, and that transportation cost, which is largely influenced by the price of oil, will have an impact on the price of product within the Core PCE index.

This is good news for the stock market going into the December Fed meeting. With the Core PCE running just below the Fed’s target 2% rate and the Headline PCE declining, there is not a big push for the Fed to raise the Fed Funds Rate in December.  I would even make the argument that raising the Fed Funds Rate in December would be a mistake.

The Fed & The Stock Market

The Fed is not a slave to the stock market. It’s not the Fed’s job to make sure the stock market continues to go up. Just because the stock market has experienced a large sell off over the past two months does not mean that the Fed will come to the market’s rescue and not raise rates.  But remember, the Fed’s job is to keep the U.S. economy at full employment and keep inflation in check.   Since inflation remains in check, it would seem that the prudent decision would be for the Fed to pause in December.  If the Fed decides to raise rates in December, I have a difficult time understanding the catalyst for that decision. 

Drivers Of The Recent Sell Off

It’s been a frustrating year for investors.  Over the past 7 weeks, the U.S. large cap index, mid cap index, and small cap index have forfeited all of their gains for the year.  International equity markets have been crushed this year.  In a year like this, normally investors could turn to the bond portion of their portfolio for some support but that has not been the case this year either. The Barclays US Aggregate Bond index is down 2.38% year-to-date in 2018.    It’s been a return drought this year with a double dose of volatility.

While the rapid rise in interest rates at the beginning of October may have triggered the market sell off, the downturn has been sustained by revisions to the forward guidance offered by corporations within their third quarter earnings report.  While it has been another solid quarter of earnings for U.S. corporations, many of the companies that have been leading the bull market rally revised their forward earnings guidance down for the next few quarters.    U.S. corporations seem to be embracing the uncertainty created by the trade wars and the tight labor market going into 2019.

It’s important to understand that as of today corporate earnings have not fallen short of expectations.  As of November 14, 2018,  456 of the 500 companies in the S&P 500 had reported 3rd quarter earnings.     77.6% of those companies reported earnings above analyst expectations.  This is above the long-term average of 64% and in line with the prior four quarter averaging of 77% exceeding expectations.

What really changed was the gross revenue numbers.  Of those 456 companies that reported, 60.4% of those companies reported Q3 revenue above analyst expectations.  That puts it in-line with the long-term average of 60% but below the average of the prior four quarters at 73%.  While the U.S. economy continues to show strength, U.S. corporations have largely built an “earnings buffer” into their forecasts.

Economic Expansions Do Not Die Of Old Age

Everyone is on the lookout for the next recession.   Each market sell off that we experience in this prolonged bull market rally makes investors question if they should run for hills.  As one would expect, as you enter the later innings of an economic expansion the markets will begin to become more volatile.   It’s easy for investors to hold their positions when the markets are going straight up with no volatility like 2017. It’s much more difficult to hold positions when it feels like you’re on a boat, in a storm, in the middle of an ocean.   The temptation to try and jump in and out of the market in these volatile market conditions becomes much greater.

It’s very difficult to predict the future direction of the stock market using the recent fluctuations in the stock market as your barometer for future performance.   If we look at many of the economic expansions in the past, we historically do not enter recession because the market calls it a day and just decides to go into a downward death spiral.  In the past, there was typically a single event or a series of events that caused the economy to go from a period of expansion to a period of contraction.  It’s for this reason that during these periods of heightened volatility that we rely heavily on the economic indicators that we track to determine how worried we should really be.

One of the main indicators that we track that I have shown you in previous updates is the Composite of Leading Indicators.   It aggregates a number of forward looking economic and market indicators in an effort to provide a measurement of the health of the U.S. economy.   See the chart below.

Each of the light blue areas shows when a recession took place going back to 1970.   As you will see, in most cases this indicator turned negative before the economy entered a recession.  If you look at what this indicator is telling us now, not only is the U.S. economy healthy, but over the past year it has strengthened.  If you look at where we are now, there has never been a time since 1970 that this economic indicator has been at its current level, and a recession just shows up out of nowhere 12 months later.

Conclusion

We have no way of knowing what action the Fed will take on December 19th.  However, given the tame level of inflation and the 3.7% unemployment rate, we would not be surprised if the Fed pauses at the December meeting which could lead to a health rally for the markets in December.   Even if the Fed throws the market a curve ball and moves forward with the quarter point rate hike, while this move may seal the markets hopes of posting a positive return for the 2018 calendar year, the economy is still healthy, the probability of a recession within the next 12 months is still very low, and interest rates, although rising, are still at historically low levels.  This economic environment may reward investors that have the discipline to make sound investment decision during these periods of heightened market volatility.   The “easy years” are clearly behind us but that does not mean that the economic expansion is over. Have a safe and happy Thanksgiving everyone!! 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Where Are We In The Market Cycle?

Before you can determine where you are going, you first have to know where you are now.  Seems like a simple concept.  A similar approach is taken when we are developing the investment strategy for our client portfolios.  The question more specifically that we are trying to answer is “where are we at in the market cycle?”  Is there more upside to the market?  Is there a downturn coming?  No one knows for sure and there is no single market indicator that has proven to be an accurate predicator of future market trends.  Instead, we have to collect data on multiple macroeconomic indicators and attempt to plot where we are in the current market cycle.   Here is a snapshot of where we are at now:

The length of the current bull market is starting to worry some investors. Living through the tech bubble and the 2008 recession, those were healthy reminders that markets do not always go up.  We are currently in the 87th month of the expansion which is the 4th longest on record.  Since 1900, the average economic expansion has lasted 46 months.  This leaves many investors questioning, “is the bull market rally about to end?”  We are actually less concerned about the “duration” of the expansion.  We prefer to look at the “magnitude” of the expansion.  This recovery has been different.  In most economic recoveries the market grows rapidly following a recession.  If you look at the magnitude of this expansion that started in the 4th quarter of 2007 versus previous expansions, it has been lackluster at best.  See the chart on the next page. This may lead investors to conclude that there is more to the current economic expansion.

Next up, employment.  Over the past 50 years, the unemployment rate has averaged 6.2%.  We are currently sitting at an unemployment rate of 5.0%.  Based on that number it may be reasonable to conclude that we are close to full employment.  Once you get close to full employment you begin to lose that surge in growth that the economy receives from adding 250,000+ jobs per month.  It may also imply that we are getting closer to the end of this market cycle.

Now let’s look at the valuation levels in the stock market.  In other words, in general are the stocks in the S&P 500 Index cheap to buy, fairly valued, or expensive to buy at this point?  We measure this by the forward price to earning ratio (P/E) of the S&P 500 index.   The average P/E of the S&P 500 over the last 25 years is 15.9.  Back in 2008, the P/E of the S&P 500 was around 9.0.  From a valuation standpoint, back in 2008, stocks were very cheap to buy.  When stocks are cheap, investors tend to hold them regardless of what’s happening in the global economy with the hopes that they will at least become “fairly valued” at some point in the future.  Right now the P/E Ratio of the S&P 500 Index is about 16.8 which is above the 15.9 historic average.  This may indicate that stock are starting to become “expensive” from a valuation standpoint and investors may be  tempted to sell positions during periods of volatility.

Even though stocks may be perceived as “overvalued” that does not necessarily mean they are not going to become more overvalued from here.  In fact, often times after long bull rallies “the plane will overshoot the runway”.  However, it does typically mean that big gains are harder to come by since a large amount of the future earnings expectations of the S&P 500 companies are already baked into the stock price.  It leaves the door open for more quarterly earning disappointments which could rise to higher levels of volatility in the markets.

The most popular question of the year goes to: “Trump or Hillary?  And how will the outcome impact the stock market?”  I try not to get too deep in the weeds of politics mainly because history has shown us that there is no clear evidence whether the economy fares better under a Republican president or a Democratic president. However, here is the key point.  Markets do not like uncertainty and one of the candidates that is running (I will let you guess which one) represents a tremendous amount of uncertainty regarding the actions that they may take if elected president of the United States.  Still, under these circumstances, it is very difficult to develop a sound investment strategy centered around political outcomes that may or may not happen.   We really have to “wait and see” in this case.

Let’s travel over the Atlantic.  Brexit was a shock to the stock market over the summer but the long term ramifications of the United Kingdom’s exit from the European Union is yet to be known.  The exit process will most likely take a number of years as the EU and the UK negotiate terms. In our view, this does not pose an immediate threat to the global economy but it will represent an ongoing element of uncertainty as the EU continues to restart sustainable economic growth in the region.

The chart below is one of the most important illustrations that allows us to gauge the overall level of risk that exists in the global economy.  When a country wants to jump start its economy it will often lower the reserve rate (similar to our Fed Funds Rate) in an effort to encourage lending.  An increase in borrowing hopefully leads to an increase in  consumer spending and economic growth.  Unfortunately, countries around the globed have taken this concept to an extreme level and have implemented “negative rates”.  If you buy a 10 year government bond in Germany or Japan, you are guaranteed to lose money over that 10 year period.  If you have a checking account at a bank in Japan, instead of receiving interest from the bank, the bank may charge you a fee to hold onto your own money.  Crazy right? It’s happening.  In fact, 33% of the countries around the world have a negative yield on their 10 year government bond. See the chart below.  When you look around the globe 71% of the countries have a 10 year government bond yield below 1%.   The U.S. 10 Year Treasury sits just above that at 1.7%.

So, what does that mean for the global economy?  Basically, countries around the world are starving for economic growth and everyone is trying to jump start their economy at the same time.  Possible outcomes?  On the positive side, the stage is set for growth.  There is “cheap money” and favorable interest rates at levels that we have never seen before in history.  Meaning a little growth could go a long ways.

On the negative side, these central banks around the global are pretty much out of ammunition.  They have fired every arrow that they have at this point to prevent their economy from contracting. If they cannot get their economy to grow and begin to normalize rates in the near future, when they get hit by the next recession they will have nothing to combat it with.   It’s like the fire department showing up to a house fire with no water in the truck.  The U.S. is not immune to this situation.  Everyone wants the Fed to either not raise rates or raise rates slowly for the fear of the negative impact that it may have on the stock market or the value of the dollar.  But would you rather take a little pain now or wait for the next recession to hit and have no way to stop the economy from contracting?   It seems like a risky game.

When we look at all of these economic factors as a whole it suggests to us that the  U.S. economy is continuing to grow but at a slower pace than a year ago.  The data leads us to believe that we may be entering the later stages of the recent bull market rally and that now is a prudent time to revisit the level of exposure to risk assets in our client portfolios.  At this point we are more concerned about entering a period of long term stagnation as opposed to a recession.  With the rate of economic growth slowing here in the U.S. and the rich valuations already baked into the stock market, we could be entering a period of muted returns from both the stock and bond market.   It is important that investors establish a realistic view of where we are in the economic cycle and adjust their return expectations accordingly.

As always, please feel free to contact me if you’d like to discuss your portfolio or our outlook for the economy.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.