Powell & A Government Shutdown Hits Stocks
Last week, we noted the ongoing market churn that could last into this week’s Fed meeting. To wit:
“That certainly seemed the case this past week, with the market trading being fairly sloppy. Attempts to push the market higher were repeatedly met with sellers, and we saw a rotation from over-owned to under-owned assets. Notably, that selling pressure arrived as expected, and while such could persist until early next week, we should be getting close to the end of the distribution and rebalancing process. The good news is that the recent consolidation paves the way for ‘Santa Claus to visit Broad and Wall.”
That process continued as expected this past week but became violent on Wednesday following the Federal Reserve meeting. While the Fed cut rates as expected, the market shock came from the lift in its outlook for interest rates in 2025 by a half percentage point. The market is assuming that the Fed is giving up on the idea that inflation will return to the 2% target next year, an idea that they had confidence in as recently as September. That more hawkish outlook undermined the view that elevated valuations were justified by easier monetary conditions, which now seems to be reversing. We suspect that this view is rather short-sighted, and given the economic dynamics both abroad and in the U.S., slower economic growth will lead to a “dovish” pivot by the Fed in the first half of 2025.
The markets also struggled with concerns about a Government shutdown. As we discussed in October 2023, shutdowns are NOT a threat to the market in the long term. To wit:
“What is critical to understand about Government shutdowns is that mandatory spending (social security, welfare, interest on the debt) continues as needed. Shutdowns are primarily about discretionary spending. Such is why it mainly involves Government employment and the shuttering of national parks and monuments. According to Goldman Sachs, the shutdown would have only impacted about 2% of Federal spending overall. Notice that the vast majority of Government spending is directly a function of the social welfare system and interest on the debt.”
Please note that during a Government shutdown, all MANDATORY spending continues. In other words, the government WILL NOT default on its debt, and social security payments will continue, despite rhetoric to the contrary.
Furthermore, market reactions to government shutdowns have become increasingly muted. The reason is that the markets have learned that funding typically arrives at the 11th hour via a ‘continuing resolution’ to provide temporary funding through the next political event, such as midterm elections, inauguration, etc. While these short-term spending bills eventually translate into longer-term spending bills, the real problem is that continuing resolutions (CRs) increase spending by 8% annually. Such is why debt has exploded since Congress stopped passing budgets in 2009 under President Obama and opted for CRs. The debt surge is the direct result of automatically compounding 8% annual spending increases plus additional spending.
However, as shown, government shutdowns, if they occur, can temporarily impact markets, but the event tends to be mild and short-lived.
Nonetheless, the market has triggered a short-term MACD sell signal, which warned investors that some “event” could exert downward pressure on stocks. As noted, the Fed and “Government Shutdown” drama sufficiently triggered sellers as portfolio rebalancing and distributions concluded. With relative strength oversold on Friday, the setup for a reflexive rally into year-end has become a much higher-probability event. However, the ongoing sell signal is deep enough to limit whatever reflexive rally does arrive. Such is particularly true as money flows have deteriorated over the last few weeks.
While we still expect a rally into year-end, as we will discuss, there is a not-so-insignificant possibility of further turmoil. We suggest continuing to manage risk, and with significant gains already booked for this year, there is little need to stretch for further returns at this juncture.
Will Santa Claus Visit Broad And Wall?
Will “Santa still visit Broad and Wall?” That is the question on everyone’s mind. As we will discuss, there are certainly reasons to be concerned, but let’s start with the market statistics and reasons behind the fabled year-end rally.
The actual Wall Street saying is, “If Santa Claus should fail to call, bears may come to Broad & Wall.” The Santa Claus Rally, also known as the December effect, is a term for more frequent than average stock market gains as the year winds down. However, as is always the case with data, average returns sometimes differ from reality.
Stock Trader’s Almanac explored why end-of-year trading has a directional tendency. The Santa Claus indicator is pretty simple. It looks at market performance over a seven-day trading period – the last five trading days of the current trading year and the first two trading days of the New Year. The stats are compelling.
“The stock market has risen 1.48% on average during the 7 trading days in question since both 1950 and 1969. Over the 7 trading days in question, stock prices have historically risen 76% of the time, which is far more than the average performance over a 7-day period.“
The end of the year tends to be strong for a couple of reasons. First, professional managers tend to “window dress” portfolios for year-end reporting purposes. Secondly, given that many professional funds make year-end distributions, there tends to be a need to rebalance portfolios. The following graph in orange shows aggregate cumulative returns by day count for the December months we analyzed. In the graph, we plotted returns alongside daily aggregated average returns by day. Unsurprisingly, the recent sloppy trading and correction this past week all coincide with the historical norms of December.
Visually, one notices the “sweet spot” in the two graphs between the 10th and 14th trading days. The 14th trading day, in most cases, falls within a few days of Christmas.
However, there is always a risk.
Did The Fed Steal Christmas?
While there is a decently high probability that stock prices will climb heading into year-end, there is a not-so-insignificant 24% chance they won’t. With the substantial November advance and new highs into early December, the question is whether anyone is “left to buy?” As noted, not every December has a “Santa Claus Rally.” 2018, as shown, is a good reminder that once in a while, investors receive a lump of coal in their stockings. At that time, the Federal Reserve was on a rate hiking campaign and insisted that it was “nowhere near the neutral rate” on monetary policy. Furthermore, since the market had declined steeply since early September, sentiment and investor positioning were very negative.
Interestingly, December 2024 has some of the same backdrops as September 2018.
First, the S&P 500 rallied strongly this year, approaching our year-end target of 6000. That rally has led to a sharp increase in bullish sentiment between retail and professional investors. As shown, U.S. equity allocations are at record highs among professional investors.
Furthermore, like in 2018, when retail equity allocations and valuations were elevated, investor allocations are at the highest on record, coinciding with the second-highest valuation levels.
There is also an abundance of optimism about future stock prices, just like in 2018.
What is important to remember about 2018 is that investor optimism was fine until the Fed said it “was nowhere near the neutral rate.” Of course, following a 20% decline and two months later, the Fed was magically at that neutral rate.
Today, investor exuberance is tied to a further accommodative easing in 2025. However, like in 2018, the Fed suggested it isn’t near its “neutral rate,” as shown in its latest projections. While the “long-run” projections are still for economic growth of 1.8% (down from 2.0% and 1.9% previously) and inflation of 2%, the short-term outlooks for 2025 were adjusted modestly higher. That uptick disappointed investors even though the end goals remain the same, which will require Fed funds to adjust lower. (Side note: The Fed’s projections are almost always too optimistic, which suggests the recent bout of hawkishness will give way to a dovish reversal next year.)
The adjustment to the Fed’s view was minimal from an investing perspective. However, the market reacted violently because the combination of exuberance and overbought factors created the perfect environment for a reversal.
Technically Speaking
First, while the market rallied into year-end on many optimistic assumptions, breadth has been deteriorating noticeably. From the NYSE Advance-Decline line to the percentage of stocks trading above their respective 50 and 200-DMA, overall participation has declined rapidly. While such does not mean a market crash is imminent, such previous deterioration has eventually coincided with short-term corrections and consolidations. Unsurprisingly, that is exactly what happened as the collision of the Fed and a looming shutdown gave sellers the push they needed.
Secondly, the market was, and is, technically extended on many levels after the past two years of excess returns. The monthly market analysis shows the S&P 500 is significantly overbought on a relative strength basis, deviated from the long-term mean, and pushing well into the top of its bullish trend from the 2009 lows. While we discussed the same factors in the middle of 2021, it took several months before the market gave way and corrected the excesses in 2022. Given the market’s current momentum, we suspect the bullish run will likely last into the first half of next year but could be sooner if earnings expectations decline.
What is crucial to understand is that these technical extremes are just the “kindling” for a correction. To “ignite” the correction, some event must provide the catalyst. In this case, it was the more hawkish pivot by the Fed and the threat of a shutdown. As is always the case, the event that causes a sharp unwinding of the market, like we saw on Wednesday, is always unexpected. The “surprise factor” causes the sudden shift in market expectations for earnings growth and outlooks. The risk going forward is “if” the Fed is correct in its outlook, the more optimistic outlook for earnings expectations will need to be reassessed. If that is the case, the market will decline to reduce valuations for a new reality.
Given that current valuations are at the second-highest level on record, such an event would seem more likely. Notably, short-term valuations are solely a function of sentiment. Investors are paying well above the earnings growth that is occurring. Historically, earnings have disappointed those expectations.
Does any of this mean that “Santa Won’t Visit Broad And Wall?” Of course not. However, I would not completely dismiss the risk of “getting a lump of coal” this year.
Given the uncertainty, both into year-end and 2025, how should we approach it?
Calculating The Madness
Let me repeat something that seems apropos:
Sir Isaac Newton once said:
“I can calculate the motions of the heavenly bodies, but not the madness of the people..”
As we head into year-end, we will navigate the risk of overly extended and bullish markets against the seasonally strong end-of-year period.
We believe that capital preservation and risk management lead to better outcomes over the long term. However, managing risk can be frustrating in the short run as the “Fear Of Missing Out” overrides common sense and logic.
If you disagree, that is okay.
When the opportunity presents itself and the “madness has subsided,” these are the questions we will ask ourselves before we add exposure to portfolios:
- What is the expected return from current valuation levels? (___%)
- If I am wrong, what is my potential downside, given my current risk exposure? (___%)
- What actions should I take now if #2 exceeds #1? (#2 – #1 = ___%)
How you answer those questions is entirely up to you.
What you do with the answers is also up to you.
We are all trying to answer the question, “How much of the ‘narrative’ already got priced into the market?”
By looking at the data, it would be easy to assume the answer is “much.”
While bullishness prevails, this is a great time to set aside the narratives and return our focus to the basic portfolio management rules.
How We Are Trading It
Since we have our “stockings hung by the chimney with care,” we can stuff them with a few essential investment guidelines to follow as we approach year-end.
- Investing is not a competition. There are no prizes for winning but severe penalties for losing.
- Emotions have no place in investing. You are generally better off doing the opposite of what you “feel” you should be doing.
- The ONLY investments you can “buy and hold” provide an income stream with a return of principal function.
- Market valuations (except at extremes) are very poor market timing devices.
- Fundamentals and Economics drive long-term investment decisions – “Greed and Fear” drive short-term trading. Knowing what type of investor you are determines the basis of your strategy.
- “Market timing” is impossible– managing risk exposure is logical and possible.
- Investment is about discipline and patience. Lacking either one can be destructive to your investment goals.
- There is no value in daily media commentary– turn off the television and save yourself the mental capital.
- Investing is no different from gambling—both are “guesses” about future outcomes based on probabilities. The winner is the one who knows when to “fold” and when to go “all in.”
- No investment strategy works all the time. The trick is knowing the difference between a bad investment strategy and one temporarily out of favor.
While anxiously anticipating the arrival of the “Santa Claus Rally,” we must also remember the lesson of 2018.
Nothing is guaranteed.
