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
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.
This review and outlook report (this “Report”) is for informational, illustration and discussion purposes only and is not intended to be, nor should it be construed as, financial, legal, tax or investment advice, of Brenton Point Wealth Advisors LLC or any of its affiliates (“Brenton Point”). This Report does not take into account the investment objectives, financial situation, restrictions, particular needs or financial, legal or tax situation of any particular person and should not be viewed as addressing any recipient’s particular investment needs. Recipients should consider the information contained in this Report as only a single factor in making an investment decision and should not rely solely on investment recommendations contained herein, if any, as a substitution for the exercise of independent judgment of the merits and risks of investments.
This material is based upon information obtained from various sources that Brenton Point believes to be reliable, but Brenton Point makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current only as of the date indicated and are subject to change without notice.
This Report contains certain forward looking statements opinions, estimates, projections, assessments and other views (collectively “Statements”). These Statements are subject to a number of assumptions, risks and uncertainties which may cause actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by these forward looking statements and projections. Brenton Point makes no representations as to the reasonableness of such assumptions or the likelihood that such assumptions will coincide with actual events and this information should not be relied upon for that purpose. Changes in such assumptions could produce materially different results. Past performance is not a guarantee or indication of future results, and no representation or warranty, express or implied, is made regarding future performance of any financial instrument mentioned in this Report.
Any benchmark shown herein is shown for illustrative purposes only. No index benchmark is available for direct investment. It may not be possible to replicate the returns of any index, as the index may not include any trading commissions and costs or fees, may assume the reinvestment of income, and may have investment objectives, use trading strategies, or have other materials characteristics, such as credit exposure or volatility, that do not make it suitable for a particular person. This is not an offer or solicitation for the purchase or sale of any security, investment, or other product and should not be construed as such. References to specific financial instruments and to certain indices are for illustrative purposes only and provided for the purpose of making general market data available as a point of reference only; they are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities. Investing in securities and other financial products entails certain risks, including the possible loss of the entire principal amount invested, as the value of investment can go down as well as up. You should obtain advice from your tax, financial, legal, and other advisors and only make investment decisions on the basis of your own objectives, experience, and resources.
Brenton Point accepts no liability for any loss (whether direct, indirect or consequential) occasioned to any person acting or refraining from action as a result of any material contained in or derived from this Report, except to the extent (but only to the extent) that such liability may not be waived, modified or limited under applicable law.
This Report may provide addresses of, or contain hyperlinks to, Internet websites. Brenton Point has not reviewed the linked Internet website of any third party and takes no responsibility for the contents thereof. Each such address or hyperlink is provided solely for your convenience and information, and the content of linked third party websites is not in any way incorporated herein. Recipients who choose to access such third-party websites or follow such hyperlinks do so at their own risk.
All marks referenced herein are the property of their respective owners. This Report is licensed for non-commercial use only, and may not be reproduced, distributed, forwarded, posted, published, transmitted, uploaded or otherwise made available to others for commercial purposes, including to individuals within an institution, without written authorization from Brenton Point.
Source of data and performance statistics: Bloomberg L.P. and Factset Research Systems Inc.
©Brenton Point Wealth Advisors LLC 2020
Director of Market Research
Michael Schaus is the Director of Market Research for Brenton Point Wealth Advisors and Zweig-DiMenna. Since joining Zweig-DiMenna in 1992, his focus has been on macroeconomic research, the analysis of…READ MORE