Strong Year-End Rallies: Positive for Q1

This month we discuss more extremes in the market and their implications. Despite investors increasing equity exposure from last month, the continued strong economic outlook combined with a committed Federal Reserve and benign inflation readings, our equity ratings remain bullish along with commodities and gold. However, after a 10-week 17% rally in the S&P 500, a 5-8% decline should be expected at any time. Long-term bonds remain at a cautious 1 rating, due to the asymmetrical risk presented by low interest rates. The political violence in Washington, DC and the COVID case acceleration are certainly serious issues for all of us, but for now they are not affecting our ratings.

Strong Year-End Rallies: Positive for Q1

The S&P 500 finished 2020 14% above the 200-day average, one indication of the strength of the equity rally. For perspective, this reading is in the 97th percentile since 1990. In the 9 prior cases since 1950, the S&P 500 was higher by the end of Q1 in every case, and the best rally within 3 months averaged 7%, or 28% annualized. In other words, in prior cases, Q4 strength carried over into Q1.

The maximum declines within Q1 averaged just 3%. T he worst case was in 1981 when the S&P 500 declined 6%, the Fed was hiking rates and inflation was 12%, very different conditions from today.
Finally, the next 6% move from year end was higher in all but the 1981 case.

Chart 1: S&P 500 Return after S&P 500 10% Over 200 Day at Year End MIXED 1 Month Out, All Higher 3 Months Out

December ISM Manufacturing Index Extreme: Positive with Loose Fed

The ISM manufacturing index is a very coincident U.S. economic indicator. For December it was up 3 points to 60.7, an extreme reading in the 99th percentile since 1990. This marks a full reversal from the low point of 41 in April. The inflation component part of the report, called Prices Paid was up 12 to 77.6, the highest since 2018 and in the 92nd percentile since 1990. Although CPI inflation is just 1.2% Y/Y, the ISM index prices paid reflects input prices like energy prices which have moved higher. Most investors assume a strong economy is bullish for stocks. However, this combination of a strong economy and higher inflation readings was mixed for stocks since 1950, showing just a 0.5% return (conditions have occurred 13% of the time).

However, the issue historically has been Fed tightening. In prior cases the Fed would at least be discussing an initial hike (like 2004) if not actually hiking (like 2018 case). With the easy Fed like we have today, S&P 500 returns were positive. For instance, the S&P 500 returned 14.6% annualized since 1950 when the ISM was strong and the Fed was loose. This combination was consistent over time as well, giving us confidence the economy is not yet overheating.

Chart 2: ISM Manufacturing Index 60.7: 99th Percentile since 1990

10-Year Treasury Yield Up: Positive for Equities and Commodities

As the economy has strengthened, the 10-Year Treasury Yield is up 0.65% since August to 1.15% as of January 11th . This is the biggest move higher since early 2018. Generally rising interest rates are negative for equity returns. However, tests show a rising 10-year yield when the Federal Reserve is accommodative is positive for stocks. For instance, since 1990 when the 10-year yield was up more than 50 bps in the prior 6 months and the Fed was easing, the S&P 500 returned double the norm, 20.8% annualized (these conditions have occured 8% of the time). That compares to a below the norm return of just 6.2% when the 10-year yield was rising, and the Fed was hiking rates. It actually makes sense since rising rates tell you the economy is strengthening; a loose Fed however means the cycle will be allowed to continue.

The combination is also positive for commodities like crude oil, with a 28.3% return, 10x the norm since 1990. Generally rising rates are bullish for the dollar as well, but tests show the dollar returned 10.9% annualized since 1990 with this combination. There may be a concern at some point the Fed is behind inflation, especially since they have stated they want higher inflation. This means a weaker dollar and stronger gold prices. Gold returned 10.5% with this combination, 2x the norm since 1990.

Chart 3: 10-Year Yield vs. S&P 500

Chart 4: 10-Year Treasury Yield is Rising: Positive for S&P 500

Equity Investor Positioning Long Equity investor

Equity investor positioning is more extreme than we discussed in December. Today all 10 equity investor groups we track are now long equities, and 8 of the 10 are extreme up from 6 in December. It’s a great case study in investor behavior, since this compares to extreme pessimism in April after the S&P 500 had declined 33%. At that point 9 of 10 investor groups were pessimistic. However, the implications are more complicated. Extreme optimism implies less cash available to push stocks higher, but there are many periods when most investors were bullish and equities continued higher, particularly when other conditions were positive as they are today. For now, positive monetary, economic and momentum conditions are an offset to the extreme positioning.

Chart 5: Investor Sentiment: April 2020 vs. January 2021:Extreme Pessimism to Extreme Optimism

Summary

Prior cases show the strong Q4 move higher in equities is likely to follow through in Q1. Political violence, COVID case acceleration and extreme investor positioning are certainly reasons for concern, but for now the strong economic outlook combined with a loose Federal Reserve is setting the expected return for stocks above the norm. After COVID vaccines are more widely distributed, we may see further economic upside, but that may be time for equity market consolidation after such an extreme move to the upside. We will continue monitoring our array of indicators and testing our assumptions on a daily basis. Thank you for your support, and please contact your advisor with any questions.

 

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