Market Update - We got our Santa Rally, now what?
We got our Santa Rally, now what?
The major US stock indices rallied sharply into the Christmas week. The Dow and S&P went on to hit record intra-day highs on the second full trading day of 2022, thereby confirming an ‘official’ Santa Rally. Following this, equities pulled back sharply in a move catalysed by the release of minutes from the Federal Reserve’s FOMC December meeting. The minutes confirmed that the US central bank was increasing the rate at which it would taper its bond purchase programme. They also implied that rate hikes would quickly follow, leading the market to price in three, or even four, 25 basis point rate hikes with the first coming as soon as March, rather than May as previously forecast. But the biggest hawkish surprise came as committee members said they were prepared to start reducing the Fed’s balance sheet sometime after their initial rate hike. This was unexpected and the news spooked investors. That’s hardly surprising. Back in 2018 the Federal Reserve simultaneously raised rates and reduced its balance sheet, something that had never been tried before. It was viewed as a rather reckless experiment as it was impossible to judge which of the two actions were having the biggest effect in reducing stimulus, making any fine-tuning problematic. It was also feared that this two-pronged reduction in fiscal stimulus could destabilise risk assets and undermine confidence. And so, it came to be. Investors grew increasingly wary, and by September many demonstrated their concern by reducing their exposure to equities. This led to a rout in which the S&P 500 fell over 20% in the last quarter of the year. Jerome Powell was forced to backtrack, announcing in January 2019 that monetary tightening was over. Five months later the Fed cut rates from 2.5% to 2.25%, its first reduction since December 2008. By March 2020, as central bankers around the world reacted to the Covid-19 pandemic, they were back below 0.25% where they remain to this day.
They bought the dip - again
This New Year’s sell-off has also unsettled investors. We moved from the ‘Santa Rally’ trading trope to the ‘as goes January, so goes the rest of the year’ cliché. At the time of writing, it appears that the pull-back has proved to be yet another ‘buy the dip’ opportunity, although there’s still no guarantee that it can’t morph into something more concerning. The sell-off was led by the tech sector which has most to lose from higher interest rates. Typically, this sector benefits from low borrowing costs as companies get cheap loans now on the expectation of high growth in years to come. As far as the S&P 500 is concerned, it once again fell back to its 100-day exponential moving average from where it bounced sharply. Going into 2022, there are plenty of commentators who are warning that stock markets are overdue a more serious correction. Bear in mind that we saw most stock indices push higher over the past twelve months with the major US indices posting solid gains. The S&P 500 rose just under 27%, while the Dow Jones Industrial Average and NASDAQ made gains of 19% and 21% respectively. Notably, the S&P made 70 record closing highs in 2021, its best run since posting 77 new highs in 1995. Last year’s action was typical during the heart of bull markets where prices grind higher with shallow pullbacks. This makes it very difficult for those on the side-lines to get involved. The relentless gains only go to frustrate traders who haven’t bought already, sparking the dreaded FOMO (Fear of Missing Out). Yet many are understandably scared of buying at what may prove to be the top. So, they sit on their hands, becoming ever more impatient, waiting for a significant sell-off which never seems to come. Then when it does appear, the size and speed of the fall often terrifies investors who fear even greater losses, so fail to take advantage of lower buying prices.
Some commentators maintain that a full-blown crash is on the cards. Certainly, many of the major US stock indices are historically overvalued. Within these indices you have companies like Tesla. Despite selling less than 900,000 cars per year, or around 1% of the car market, it currently has a market capitalisation of around $1 trillion which makes it worth around the same as the next 10 most valuable global automakers combined. Tesla has a price-earnings ratio of around 332, in an industry where PE ratios of 10 to 30 are typical. It’s only natural that market commentators should become increasingly bearish as assets increase in value. As Hyman Minsky noted, stability breeds instability. The longer something goes on for, the more we worry that it’s coming to an end. But if that’s the case, why are people worrying so much now? We had an almighty market crash less than two years ago. Doesn’t that count? Just because many global stock indices bounced back quickly and went on to make fresh record highs (not the UK’s FTSE 100, by the way) doesn’t make it the ‘wrong sort of crash.’ We’re currently climbing a ‘wall of worry’ and adjusting to the post-Covid 19 world. Yes, valuations may be stretched (looking at you Tesla) but there are reasons for this. Monetary and fiscal stimuli are lifting asset prices. Corporations, in the US and elsewhere, are producing bumper sets of financial results, busting expectations for both earnings and sales.
Inflation is persistent
But there’s also sense in the bearish argument. Equities, especially those in the growth sector, are highly rated, propped up by monetary and fiscal stimulus which are keeping borrowing costs at historically low levels. US inflation, as measured by the Consumer Price Index (CPI) is, at 7% year-on-year, at a forty year high. The Federal Reserve has made it clear that it will tighten monetary policy this year to reduce inflationary pressures. Some say this will damage economic growth and corporate sales and earnings will suffer. Higher borrowing costs will crimp demand, and force governments either to cut spending, or print more money and deal with even higher inflation, which could spiral out of control. But others maintain that markets are pricing in tighter conditions, and three rate hikes this year would see the Fed funds rate at less than 1% - hardly disastrous.
The major US indices are all trading at, or around, all-time highs. As far as the S&P 500 is concerned, the 50, 100 and 200-day moving averages are all stacked up in bullish fashion. The September sell-off of between 5-7%, depending on the index (so, not even in correction territory) ended when the MACD became extremely oversold. We saw something similar in November/December, and again in early January. By the same token, bull markets can look overbought and remain that way for long periods without suffering significant pullbacks. All in all, it’s still very much a market where investors and speculators are desperate for dips to buy, and, until the last few months, they’ve been disappointed. Another correction looks well overdue and would be most welcome to clear the air. But overall, while a significant correction could come at any time, the market doesn’t look ready to crash – not yet anyway.