After the deluge of red ink in September and October, we have told our clients to expect the stock market to rally to close the year. Of course, when you say such things, you have to incorporate any number of caveats to avoid the perception of guaranteeing returns. That is a big no-no in the industry.
So, what’s the harm of saying idioms like “good Lord willing and the creek don’t rise” or something along those lines? None, that I can see. Further, the odds are the markets will rally in November and/or December.
That is just what they tend to do at the end of the year.
Regardless, the strength of the rally in stocks we have experienced thus far in November (through 11/17) has surprised a lot of people. You can count our investment committee and yours truly among them. While we aren’t prone to looking gift horses in the mouth, this one has had some curious orthodontia work.
Reasons for the Rally
- The most oft given reason for the strength is the better-than-expected inflation data, specifically the Consumer Price Index (CPI). Although the monthly change in the CPI was only 0.1% less than expected, a breakdown of the data showed price increases largely cooling across the board. This was especially true for goods.
- As a result, the Fed Funds futures market on the Chicago Mercantile Exchange has essentially erased any potential for another rate hike.
Put another way, the investment markets are now convinced the Fed tightening cycle is finally, mercifully, over. In truth, the way all of the data is trending, it would take an act of the Almighty to convince me another rate hike is warranted.
But +7.63% for the S&P 500 for the month through 12:33 CST on 11/17/2023? That seems a bit excessive, does it not? You can almost liken it to a football team leaving its first string in the entire game during a blowout of a lesser opponent.
Hey, man, save some of this awesomeness for the next game, and let’s not get anyone hurt. Okay?
You see, the thing is, the markets aren’t really all that cheap. Sure, the earnings yield of the S&P 500 (the inverse of the price/earnings multiple) is slightly higher than the yield to maturity of the 10-Year US Treasury Note. I fully understand that. However, it isn’t by as much as it was this time last year.
Here, the math.
- Currently, the earnings yield of the S&P 500 is 4.51% (1/22.19).
- The 10-Year yield is 4.42%. Basically, that is almost on top of one another, suggesting investors should almost be ambivalent about whether they buy stocks or bonds.
- Comparatively, on 11/18/2022, these numbers were 5.34% and 3.83% respectively. This would suggest stocks were easily the more reasonably valued of the two primary assets classes, at least relatively.
- For grins, the earnings yield of the S&P 500 on 11/19/2021 was 3.96%, whereas the 10-Year only paid 1.55%. Again, that is another slam dunk for stocks.
All of this is to say, the more we rally from now through the end of December, the greater the likelihood is we would just “be stealing performance from the 1st quarter of 2024.” After all, virtually no one is predicting a sharp spike in corporate profitability during the 4th quarter.
Further, the prevailing wisdom is the Fed won’t start cutting rates until May of next year.
Essentially, what would be the fuel to drive stocks higher at the start of 2024 IF the earnings yield of the S&P 500 is eventually less than the yield on the 10-Year? Hey, I get this is Nerd City stuff. So, let me answer that question with: the fuel to drive the markets higher in that scenario would be a tankful of wishful thinking.
The wishful thinking in this case would be that the Fed starts cutting the overnight target lending rate sooner than May.
Of course, that would mean an unwinding of the trade, read rally, if the Fed doesn’t start cutting until some point later in the year.
By unwinding? You guessed it, I mean a sell-off in aggregate. The magnitude of which is impossible to pinpoint. However, the higher it goes from here, the more it will fall from there.
Some of you might be screaming: “Norris, you worrywart (or worse). There is always multiple expansion when the Fed cuts rates.” In layman’s terms, this means people are willing to pay higher prices for stocks when the cost of money starts getting cheaper. Historically, the data would certainly seem to support this argument, at least on its face.
Still, I haven’t answered the question at hand.
How much longer will the rally last?
In truth, that is almost impossible to predict with certainty. Further, there really isn’t any reason for stocks to fall between now and the end of the year. Valuations? We probably aren’t quite there yet. Earnings? For all intents and purposes, we are out of the traditional earnings season. So, corporate profitability, or lack thereof, probably won’t be a huge issue. Probably.
An expansion of the war in the Middle East? The war in Ukraine? A Chinese invasion of Taiwan? A major terrorist attack in the UA? In a word, yes. These so-called Black Swan events could or would drive a stake into the heart of the market. However, are you willing to make a bet on it or them?
That leaves me, arguably, looking at gift horses in their mouths, bloviating about negativity and wondering whether we should make some changes to our asset allocations before New Year’s Eve. These would be things like a shifting from growth to value, increasing our allocation to fixed income and, ugh, bringing our international weights to a more neutral posture from an underweight.
The Odds
This doesn’t mean we are gearing up for a repeat of 2022 in the markets. It also doesn’t mean the economy is going to completely fall about. No. It simply means, given the current data, the odds of the markets continuing to behave so ebulliently aren’t that good.
There you have it. The odds. Didn’t I start this newsletter talking about them? Or at least the odds of the markets rallying in November and December? Always with the odds.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this any every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
John Norris
Chief Economist
Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our Investment Committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.