Stocks in a Correction and the Best Month of the Year Is Here “If there were ironclad rules, we would all be following them.” -Josh Brown of Ritholtz Wealth Management Although we saw a late October bounce, the S&P 500 officially moved into correction territory last week. By definition, a correction is when stocks are down more than 10% from a recent peak, in this case, down more than 10% from the late July peak. Yes, the past three months haven’t been very fun for bulls, but let’s put some context around market corrections. Going back to 1980, the average calendar year has experienced an average drawdown of 14.3%.22 out of 44 years saw stocks experience a peak-to-trough correction of 10% or more. Out of those 22 years that had a correction we found 12 years still managed to finish higher. So it is quite possible to see a correction and stocks still finish green on the year. Lastly, for the 12 years that saw a correction and still finished higher, the S&P 500 gained 17% on average for the year. So the bottom line is a correction is quite normal and a solid year, when all is said and done, is also quite normal when we have one. According to our friends at Ned Davis Research, there are 1.1 corrections per year on average, again suggesting that while corrections aren’t fun, they’re not abnormal. We will be the first to admit the depth of the weakness in October surprised us, but we also didn’t expect to see a major war break out in the Middle East. We remain optimistic for a year-end rally though, as the economy is showing very few signs of weakness, stock valuations are getting quite attractive, and overall sentiment is very negative. Let’s talk about November for a second. Did you know this has been the best month of the year for the S&P 500? And it has been quite strong the past 10 and 20 years as well? Yes, you should never blindly invest based on just the calendar, but we wouldn’t ignore this information either. We will end with two interesting studies increasing the odds of a year-end rally. The S&P 500 was down in each of the past three months, heading into the normally bullish month of November. It turns out persistent weakness ahead of November could be a positive sign for the remainder of the year, with November higher every time (back to 1950) and the final two months together tended to do well also. The last two times we’ve seen this were in 1990 and 2016, with both years experiencing big end of year rallies the final two months. Lastly, stocks were lower in October, but still up on the year. October has seen some spectacular crashes, but this year saw more modest weakness, with stocks still up nicely for the year. We found that under this scenario stocks have been higher the past 7 times in November and the final two months together have been strong overall as well.
A Boomerang Bounce for US Stocks Fri, Nov 3, 2023 It has been a great week for the US stock market with the S&P 500 ETF (SPY) up 5.9%. Unfortunately, that only gets the market back to where it was trading just over two weeks ago on October 17th! That's because SPY fell 5.9% from 10/17 through last Friday (10/27). Right now SPY is stuck in a short-term downtrend after making a series of lower highs and lower lows since the end of July. From a technical perspective, SPY needs to make a "higher high" for things to look more positive. Today, the ETF got stuck as it approached its highs from mid-October, so it's not going to be easy. The rally this week has been broad based, but the best performing stocks have been the names that did the worst in the 10 days prior. Below we've broken the large-cap Russell 1,000 into deciles (10 groups of 100 stocks each) based on stock performance during the market's decline from 10/17 to 10/27 (last Friday). As shown, the decile of the worst performing stocks during the 10/17-10/27 pullback is averaging the strongest gains during this week's rally. Looking at individual stocks, below are the 30 best performing names this week in the Russell 1,000. At the top of the list is Roku (ROKU), which is up more than 50%! Another eight stocks are up more than 25% this week, including names like DoorDash (DASH), DraftKings (DKNG), Pinterest (PINS), Paramount (PARA), and Palantir (PLTR). Other noteworthy stocks up big this week include Wayfair (W), Block (SQ), Avis (CAR), Warner Bros. (WBD), Coinbase (COIN), TopBuild (BLD), and even Peloton (PTON).
Why We Think the October Payroll Report Was Just What the Doctor Ordered for Markets and The Fed The October payroll report was weaker than expected on several fronts: Monthly job growth came in at 150,000, below expectations for a 180,000 gain. The unemployment rate ticked up from 3.8% to 3.9% Average hourly earnings growth rose at an annualized pace of 2.5% in October, well below expectations for close to a 4% increase. But here’s some perspective on those numbers: Job growth was impacted by the United Auto Workers strike, which pulled manufacturing employment down by 33,000, and those are going to come back next month. Monthly job growth numbers can be noisy, and so the 3-month average is helpful to look at – that’s running at 204,000, which is above the 100,000 – 125,000 required to keep up with population growth. The unemployment rate doesn’t stay steady, nor does it keep going down in a straight-line during expansions. Between 1996 and 1999, the unemployment rate averaged 4.8%. A few days back the Bureau of Labor Statistics reported that layoffs are running around 1.5 million a month, which is well below the average 1.8 million in 2019. As a percent of employment, the layoff rate is now at 1% – before the pandemic, this averaged 1.2-1.3%. I’ve cut off the y-axis in the chart below to show what’s happening more clearly (layoffs surged in March-April 2020 during the pandemic). The October payroll report tells us that the economy is slowing from its red-hot pace. However, we believe that’s just normalization rather than anything recessionary, for now. But as the title of the blog says, this normalization is just what the doctor ordered for markets, and especially the Federal Reserve (Fed). Good News: Fed Rate Hikes Are Probably Done Here’s how markets reacted to the payroll report: Equity markets surged, rising more than 0.5% in the morning. The 10-year yield fell to 4.5% – it was around 5.0% 10 days ago. The probability of a Fed rate hike in December collapsed to under 10%, and the probability of one in January is now under 15%. Safe to say, investors think the Fed is done with rate hikes, and they’re taking that as a big positive for equity markets. The 10-year yield had been rising for a few months now on the back of one strong economic data point after another, culminating in the Q3 GDP report which showed the economy growing at 4.9% last quarter. Things were bound to turn sooner rather than later – the economy certainly wasn’t going to grow anywhere close to that going forward. But we believe the underlying speed of the economy is close to trend, around 2.5%, versus falling into a sharp slowdown, or even a recession. The Fed kept interest rates steady at 5.25-5.5% at their November meeting, pausing for the second meeting in a row. At their September meeting, members had penciled in one more rate hike for 2023. However, in his press conference, Fed Chair Powell brushed this away, saying the efficacy of those projections deteriorates within three months, and that Fed members could change their views at their December meeting. Powell went on to say that risks are more balanced now, unlike last year. Last year the risk was that they wouldn’t do enough to curb inflation, and so they moved aggressively. However, right now, there’s also a risk of doing too much, and unnecessarily sending the economy into a recession. They believe that the cumulative impact of everything they’ve done so far is yet to impact the economy. Moreover, if inflation continues to head lower, which is likely with wage growth cooling, we could see the Fed pivot to rate cuts by the middle of next year. Average hourly earnings are running at a 3.2% annualized pace over the past three months, almost matching what we saw pre-pandemic. That’s still strong, but something the Fed can live with. If inflation looks to be on a sustainable path to their target of 2%, we could see them pivot sooner rather than later. By itself, keeping rates where they are when inflation is falling means policy is implicitly getting tighter. Powell doesn’t sound like someone who wants that. And if economic growth is at risk, they could act even more aggressively. One thing we’ve seen with the Powell-led Fed is that they’ve been quick to pivot and act aggressively when they realize they’re behind the curve. In 2018-2019, financial stresses and a slowdown prompted an about-face and led them to eventually cut rates. In 2020 March, facing a deep recession, they didn’t hesitate to take rates to zero and took a series of aggressive measures to ease stresses in financial markets. In 2022 June, facing a 40-year high in inflation, they pivoted to a much more aggressive pace of tightening. Looking ahead, what’s interesting is that a normalizing economy could result in looser financial conditions, which could boost cyclical activity. A lower 10-year interest rate will push mortgage rates lower and that could spur more activity in the housing market. Business investment will also likely rise. Lower inflation will translate to consumers having more in their wallets as well, not to mention the fact that some household real estate wealth could be unlocked if there are refinancing opportunities. Think of someone who bought a mortgage at 8% but can now refinance at 6.5%. My colleague, Barry Gilbert, recently wrote about how there’s a lot of pent-up strength in the economy, despite all the pessimism. Throw potentially easier monetary policy into the mix of an already resilient economy, and we may have a strong catalyst for equity markets to gear shift higher.
Still Bullish – Even After S&P 500 Daily Winning Streak Ends Including the current S&P 500 daily winning streak there have been 233 six-day (or longer) Winning streaks by S&P 500 since 1950. The current 8-day streak has added 6.4% to the S&P 500 since it began on October 30. This is better than the average performance of the past 34 times that S&P 500 has been up eight days in-a-row, but well below the 11.9% S&P climbed in an eight-trading-day streak from March 12 to March 21, 2003. History cannot tell us when this current streak will end. However, it does indicate increasingly longer streaks are infrequent. Although S&P 500 has gone as long as 14 days without a decline (March 26 to April 15, 1971), it has done so just once in nearly 74 years. When the streak does end, all is not lost. As you can see in the following chart of the 30 trading days before and 60 trading days after the past 7-, 8-, and 9-day daily winning streaks ended, S&P 500 continued to move higher on average over the next 60 trading days.
Historic Sentiment Shift Thu, Nov 9, 2023 The S&P 500 and Nasdaq have extended their impressive winning streaks and that has resulted in a surge in bullish sentiment. The latest weekly AAII sentiment survey showed that 42.6% of respondents reported as bullish this week. That is now the highest level of bullish sentiment since the first half of August and perhaps more notably, a major turnaround from last week's multi-month low of 24.3%. As shown below, bullish sentiment's 18.3 percentage point rise week over week is a historically large jump in optimism, especially in more recent years. That week-over-week increase ranks as the 22nd largest in the survey's history. It also just barely edged out the 17.88 percentage point increase in November 2020 for the largest one-week increase since July 15, 2010, when it had risen 18.43 percentage points. The surge in bullish sentiment borrowed heavily from those formerly reporting as bearish. Bearish sentiment jumped above 50% last week, the highest reading since last December, but was nearly cut in half this week as it came in at only 27.2% Whereas the jump in bullish sentiment was historically large, the resulting drop in bearish sentiment is even more significant ranking as the fourth largest on record. Given there were historic moves across both bullish and bearish readings, the bull-bear spread in turn has experienced a top 1% week-over-week move. Only one week ago, the spread indicated that bears outnumbered bulls by a wide margin of 26 percentage points. Rising an astounding 41.4 points week over week, that spread is back in favor of bulls at 15.4.
Why We Think The Bull Market Should Continue In 2024 2023 has been a year unlike any other, then again, all years are unlike other years. From everyone expecting a recession and continuation of the bear market at the start of the year, to the regional banking crisis in March, to one of the best first halves to a year for stocks ever, to a seasonally rough third quarter, to the terrible war in the Middle East, to the standard late October low and year-end rally. Yes, I’ve added that last prediction ahead of time, but we do feel confident we will see a chase into the New Year. It really is amazing though how this year has played out to form. Pre-election years tend to be strong, especially when you have a new President. Not to mention there still hasn’t been a recession in a pre-election year since WWII. August and September were rough and stocks corrected into a typical late October panic low. Sure, things weren’t that simple, but when you look back, it is incredible how well things played out to the potential script. So what could be next? Do we think this bull market that started in October 2022 has legs? We sure do. In the end it comes down to the macro backdrop and as we’ve explained for months now, the economy is on firm footing. Sure, things are ‘slowing down’ some, but we like to say they are normalizing, not slowing down. Could we really keep growing at 400k jobs a month like last year? No, but a steady 150k to 200k is perfectly normal and in line with pre-COVID trends. The consumer remains strong and incomes are growing at a very healthy clip as well. If we can avoid a recession next year (our base case), then we think the chances of a year with potential low double digits returns is quite likely. What will help drive stocks higher and likely to new all-time highs during the first half of next year? At the end of the day it is earnings. We’ve seen analysts continue to come in way too low on estimates and this trend likely continues. The third quarter was expected to see earnings fall slightly, now S&P 500 earnings are expected to come in up close to 6 percent. Looking ahead, companies in the S&P 500 now expect to see record profits over the next 12 months. You know what tends to happen when profits are at a record? Stocks tend to follow, something we expect to see in 2024. Potentially even more surprising as record profits is profit margins improving. What have we heard nonstop for the past year? Profit margins are too high and must fall. Well, since March we’ve seen forward 12-month profit margins increase. If both profits and profit margins are increasing next year, that should be a nice tailwind for equities. We noted many times that a pre-election year tends to see strong equity returns, which has played out nicely once again in 2023. Here’s where things get interesting though. Did you know that under a first-term President the returns were weak early, especially during a midterm year, then get much better during the pre-election and election year? Well, so far things have played out quite well with a very weak midterm year and solid pre-election year. Why is this? It could be as simple as when a President is up for re-election there are certain levers they can pull to get the economy and thus stocks into a better mood. In fact, 2000 and 2008 were horrible years for stocks, yet those were lame duck Presidents in an election year. Diving into the data more showed a very interesting development and that is stocks have been higher during an election year of a new President going back to the past 10 Presidents! Even the historically strong pre-election year can’t say that. Higher the past 10 times and up 12.2% on average isn’t anything to ignore and that is inline with a potential low double-digit return in 2024. One final bullish development just happened last week, we saw a Zweig Breadth Thrust (ZBT). From Investopedia: Known as the Zweig Breadth Thrust Indicator, named for American stock investor and financial analyst Martin Zweig, the calculation measures how quickly sentiment in the market shifts. It does so by dividing the 10-day moving average of the number of advancing stocks by the total number of stocks. When it “thrusts” from a level below 40% to more than 60% in a 10-day period, it triggers a signal. You can read more about this signal here. The bottom line for readers is this happens when stocks go from very oversold to very overbought in a quick fashion. Think of it like a washout and then buyers step in big time. Again, this is rare, with the previous 16 times it had happened (back to WWII) that had a year of data after the signal showed higher prices every single time. Look at those green dots below, not the worst time to expect better times coming. Here’s a table breakdown of all the ZBTs we’ve seen since WWII. Again, up more than 23% a year later and never lower is something I don’t think we should ignore.
The Rise of the Mega-Caps Mon, Nov 13, 2023 In our latest Bespoke Report newsletter sent to subscribers last Friday, we provided a helpful illustration on the rise of the "mega-caps" over the last decade or so. Below is a look at the market caps of the 25 largest S&P 500 stocks ten years ago versus today. Take a close look. The 25 largest stocks in the S&P 500 now make up nearly 50% of the index versus just over a third ten years ago. Back in November 2013, the three biggest stocks all had weightings below 3%, while four stocks now have weightings above 3.75%, including Apple at 7.3% and Microsoft at 6.9%! Apple, Microsoft, Alphabet, and Amazon had a combined market cap of about $1.3 trillion ten years ago. Now each is larger than that combined number! As you also might notice, stocks 8 through 25 on the current list have weightings relatively close to their weightings from ten years ago, so it’s really just the biggest of the big stocks that have ballooned. This also tells you that virtually all the market’s gains in the last decade have come from these handful of stocks, so if you haven’t owned either these stocks or “the market,” you’ve likely lagged “the market” badly. Below is a graphical representation of the market caps for every stock in the S&P 500 today versus ten years ago, sorted from the smallest stock in the index on the left to the largest stock in the index on the right. Look at that parabolic rise of the mega-caps!
CPI Reactions Slide Mon, Nov 13, 2023 The economic data slate is light today to kick off the new week with the only US release of note being the New York Fed's Survey of Consumer Expectations (which we will cover in tonight's Closer), but tomorrow we'll get the all-important CPI report for the month of October. In the chart below, we show the daily change of the S&P 500 on each CPI release day going back to 2000. As shown, it will be the one year anniversary of what is currently the record gain on a CPI day with the 5.54% jump last November when CPI came in weaker than expected, dramatically shifting Fed pricing. S&P 500 reactions to CPI days have remained strong with an average daily gain of 0.30% on the last ten monthly CPI days, but that's down quite a bit from higher readings seen this past summer. Although last November marked an outlier of performance on CPI days, November is actually the worst month of the year for average S&P 500 daily moves on CPI days. As shown below, ironically sandwiched between two of the best months, the average decline of 0.37% in November is the worst of any month. That is because not only does November hold the record gain in 2022, but the month also boasts the record loss on a CPI day with the 6.12% decline in 2008. However, in terms of how actual results of CPI prints come in versus estimates, there does not appear to be any significant seasonal patterns. Put differently, average gains on CPI days are likely a more nuanced function of the actual results of the report and market volatility of the time rather than seasonality.
Open Season for Small Caps A Soft CPI reading this morning and a nice pop in the Russell 2000 Small Cap Index today remind us that seasonally speaking, small caps are set up for their annual yearend rally into Q1, often referred to as the “January Effect,” where small caps outperform large caps in January. Small caps have been struggling for two years now, hurt by non-transitory high inflation, the most aggressive rate-hiking regime we’ve seen since the 1980s, geopolitical turmoil with war on two fronts, fallout from pandemic and post-pandemic economic and labor woes. And the Russell 2000 small cap index recently hit a new multi-year low at the end of October. As we point out on pages 112 and 114 of the Stock Trader’s Almanac, most of the “January Effect’s” small cap outperformance takes place in the last half of December when tax-loss selling abates. Our annual November stock basket published last week for members contains some brand-new, undervalued, off-Wall-Street’s-radar small cap picks. As you can see in the accompanying chart the R2K has been tracking the pattern quite well since July and it looks like the small fry are coming out of hibernation just in time for small cap stock hunting season. Small cap stocks are facing several obstacles mentioned above, but they rallied strongly off the October 27 low with the rest of the market. As illustrated in the chart, small caps exhibit some chop from late-October through mid-December. Our small cap stock picks have historically done well as long as you honor the buy limits and stop losses. Last pre-election year in 2019 R2K had a nice rally from October to January before it was crushed by the pandemic.
Our Leading Economic Index Still Points to “No Recession” We publicly started releasing our proprietary leading economic index (LEI) in our 2023 Mid-Year Outlook, which we use to give us an early warning signal about economic turning points. We produce an LEI for the US and 29 other countries, each one custom built to capture the dynamics of those economies. The individual country LEIs are also subsequently rolled up to a global index to give us a picture of the global economy. These were all developed more than a decade ago and form a key input into our asset allocation decisions. Right now, our LEI for the US points to above-trend, or slightly above-trend, economic growth. Far away from a recession. Our index includes 20+ components, including consumer-related indicators (which make up 50% of the index), housing activity, business and manufacturing activity, and sentiment and financial markets. This contrasts with other popular LEIs, which are premised on the fact that the manufacturing sector, and business activity/sentiment, is a leading indicator of the economy. This worked well in the past but is probably not indicative of what’s happening in the economy right now. The LEI captures whether the economy is growing below trend, on trend (a value close to zero), or above trend. It can capture major turning points in the business cycle. For example, it declined ahead of the actual start of the 2001 and 2008 recessions. Last year, the index signaled that the economy was growing below trend, and that the risk of a recession was high. Note that it didn’t signal a recession, just that the “risk” of one was higher than normal. In fact, our LEI held close to the lows we saw in the prior cycle, especially in 2011 and 2016. In both of those cases, growth slowed (but continued) within a larger expansion. Both times the economy, and even the stock market, went on to recover. Right now, the situation looks better than it did a year ago. Breaking our leading economic index for the U.S. into underlying components captures how the economy has evolved since the pandemic hit three years ago. In a nutshell, the consumer has driven the recovery and carried the economy through last year. That’s in the face of major headwinds, mostly driven by a very aggressive Federal Reserve (Fed) – which adversely impacted financial conditions and borrowing costs, housing, and business investment and manufacturing. The good news is that with inflation pulling back, we could potentially see the Fed cutting rates, and that means all those headwinds are fading, and could even become tailwinds in 2024. As we look toward 2024, let’s take a look at the dynamics that may be in play. Consumption is likely to remain strong on the back of strong balance sheets. The good news about falling inflation is that it’s a tailwind for household wallets. Stronger inflation-adjusted incomes will likely power consumption going forward, and thus the economy. As I pointed out above, consumption has driven growth over the last few years, even in the face of an aggressive Fed, which normally would have resulted in a recession. A big factor was that households had a lot of excess savings that built up during the pandemic. A large portion of that was used up during the inflationary period of 2022 and after, though our estimate is that there’s still $500 billion – $1 trillion left. Nevertheless, consumption has been mostly powered by rising incomes and lower savings rates. It’s not surprising that savings rates have fallen relative to pre-pandemic – a big reason is that households are much wealthier now than they were pre-pandemic, thanks to higher home prices and stock prices. At the same time, the ability to lock in low mortgage rates when interest rates were low means debt hasn’t increased as much as household assets have. Household net worth is now 7.5 times disposable income, much higher than the 6.8 times just before the pandemic. And as the chart shows, it’s entirely because asset values have increased, while liabilities have stayed more or less the same. In fact, liabilities as a percent of disposable income are closer to where they were in the late 1990s (~ 100%), and well below 2007 levels of 136%, when households were a lot more leveraged. Easing rates should boost cyclical activity. As I wrote in my prior blog, the soft October CPI report has resulted in a pivot of monetary policy rate expectations. There’s good reason to think inflation is headed lower in a sustainable way, and that means the Fed could potentially make a few rate cuts in 2024, perhaps as early as spring. That’s going to ease borrowing costs. The immediate beneficiary of lower borrowing costs will be residential investment. We got a preview in 2023 – housing activity, especially on the single-family side (which makes up the largest part of residential investment), picked up as mortgage rates eased early in the year. Things cooled down as mortgage rates surged above 8% in the fall, but we could once again see starts and new home sales pick up as rate ease once again. It’s very unlikely mortgage rates pull back to the low levels of 2021, but even moving toward 6% could unlock a lot of activity, especially since there’s a lot of pent-up demand. The largest age cohort in America are 25-34 year olds (millennials), and that’s prime home-buying years, which is why housing activity in the new homes market hasn’t collapsed despite higher rates. Single-family starts are up 9% year over year, while new home sales are up 34% year over year. High rates have locked in existing homeowners who don’t want to sell and buy a new home with a higher mortgage. So potential home buyers are looking to the new homes market. Most importantly, new homes contribute more to economic growth because of design, construction, and engineering, in addition to brokers commissions and other transaction costs (which apply to existing homes as well). The other beneficiary of lower rates will be businesses, especially small businesses who tend to borrow more floating rate debt. That’s going to potentially improve the investment outlook and increase business activity. Business sentiment has been poor for the last couple of years, especially on the manufacturing side. This is despite hard data telling us that manufacturing production increased in 2023 and is running above pre-pandemic levels. A better financing picture will likely improve investment sentiment. All this is likely to come on top of resurging manufacturing construction activity – which has risen 94% since the end of 2020, after adjusting for inflation. Construction of facilities that manufacture computers, electronic, and electrical equipment, i.e. semiconductor and electric vehicle battery plants, have surged a whopping 900% over the same period. The inflection point came after mid-2022, on the back of the CHIPS and Science Act and the Inflation Reduction Act, which pushed grants and subsidies into reshoring manufacturing facilities. Only a portion of the money authorized by Congress has been released by the Department of Energy, and so there’s plenty more to come. Not to mention additional funds authorized as part of the bipartisan Infrastructure Investment and Jobs Act. All said and done, the economy looks nicely positioned as we head into 2024, with continued consumer strength and the massive headwind of Fed policy potentially turning into a tailwind, which is why we believe the probability of a recession in 2024 is low, perhaps only around 25%.
November Monthly Option Expiration Day: DJIA & Russell 2000 Best DJIA and Russell 2000 have been up 15 of the last 21 years on November’s monthly option expiration Friday with average gains of 0.44% and 0.42% respectively. By the way, it is not a mistake that November monthly op-ex day has the same point change and percent change in 2014 and 2015. It was triple checked and it’s correct. Full-week performance has been historically much weaker. DJIA and Russell 2000 have been down 5 of the last 6. Better than expected inflation data has lifted the market this year putting the major indexes on course for a solid weekly gain. Due to a sizable weekly loss in 2008, average performance for the week is negative across the board. Week after performance has been better, with NASDAQ and Russell 2000 strongest.
