A Sell-Off to Start the New Year

Starting in early December, with the market hovering at around 4.600 on the S&P 500, we noticed the first signs of extreme greed permeating investor psychology. The Fed had just shifted its tone from “one more hike” to “several cuts incoming next year”. Not surprisingly, as investors have been conditioned for the past decade to bid the market once the Fed hints at loosening policy, a rally started into the end of the year. At that time, in our December 04 Weekly Preview, we noted:

The equity market has finally reached overbought and extended levels of sentiment which closely align with previous market peaks. In the past 2 years, these types of overbought conditions have been excellent opportunities to take profits and reduce exposure.

That profit taking mentality appears to have finally arrived, as 2024 started. So far, all the gains from the last 5 days of December have been wiped out and the Santa Claus indicator has produced a negative result (more on seasonality later). In classical technical analysis, important inflection points in the market “need” to be re-tested, and they work in a similar way to “magnets”.

We believe that to be the case right now, as the rally unravels. It is logical that the next support level will be found near the zone that the “Fed Pivot” rally initially started - around where the R2 level and the 50-Daily Moving Average currently reside: $454 - $460 on SPY (-2% lower). Technical upside remains at $477 (+2.14% higher), but short term momentum favors the bears.

The MACD signal has clearly crossed in negative territory from a very high value, suggesting near term downside is likely. Similar crossovers from high values in the past have preceded drawdowns of about -5% on average. If we apply the same math to the current setup (5% lower from $477), we get $453, a price level that aligns well with our technical analysis posted above.

A -5% drawdown is absolutely normal in any kind of year, and it’s something we’d label “garden variety”. RIA Advisors have produced an excellent graph describing corrections in the previous years, and the conclusion is clear: it’s a rarity to NOT get at least a -5% drawdown during any given year. With investors very exuberant to start 2024, such a correction is needed in order to restore the balance between buyers and sellers.

Seasonality in an Election Year

Generally speaking, election years bode well for the stock market. Statistics show that the S&P 500 finishes up in 76.6% of election years, with average gains of 10%. However, January can be a softer month, as Stocktraders Alamanc notes, especially as the Santa Claus Rally has failed:

“On the heels of last year’s momentous rally, the market is showing some signs of weakness causing the Santa Claus Rally to fail to materialize. Profit taking in January has become more commonplace in the last 25 years or so and January is notably softer in election years like 2024. Some profit taking is understandable following the massive rally from the end of October ranging from just over 16% for DJIA and S&P 500 to 19.9% for NASDAQ and 26.2% for Russell 2000 at their respective recent highs just before year end. But the selling over the past few days is notable and a warning sign.

The lack of a rally can be a preliminary indicator of tough times to come. This was certainly the case in 2008 and 2000. A 4.0% decline in 2000 foreshadowed the bursting of the tech bubble and a 2.5% loss in 2008 preceded the second worst bear market in history. Down SCRs were followed by flat years in 1994, 2005 and 2015, and a mild bear that ended in February 2016. Of the 15 down SCRs since 1950, 10 years have been up and 5 down, but the average gain is a measly 5.0%. As Yale Hirsch’s now famous line states, ‘If Santa Claus should fail to call, bears may come to Broad and Wall.’”

Seasonal analysis now moves to “the first 5 days of the year” and the January barometer. There is an old Wall Street axiom that says: “So goes the first five days of January, so goes the month, so goes the year.”

While all of this may seem like stock market superstition, there are solid stats that back up these adages. On the bullish side, optimism from 2023 should carry over in 2024 and provide significant tailwinds. As shown in the table below, compiled by Carson Investment Research, when the market has a return on 20% or more, the following year tends to be positive as well. Just not to the same extent as the preceding year (+10% average / +12.1% median, 80% odds of positive returns). This aligns well with average election year performance.

Having a solid grasp of historical statistics is well and fine, but the more important aspect is how we choose to interpret and work with this data. We are firm believers of fundamental analysis, and the platform Dashboard clearly displays the risk-reward proposition on a longer term time horizon derived from fundamental data.

If we take an average of the 2 scenarios, this leaves us with around 4.5% upside from current levels. This is consistent with the seasonal readings so far. An important takeaway is that we are in a “buy-the-dip” environment. As long as support holds, adding to equity exposure on a drawdown should work out fine by the end of the year.

It’s just the current prices in the equity market that don’t make sense. However, the odds of the 2 scenarios don’t add up to 100%. So what’s the outlier case and what could trip up the market more seriously going forward?

What does the Fed know that we don’t?

The market rally since early November has been entirely a function of valuation expansion, not EPS growth. We can see this clearly if we study the Market Fundamentals dashboard.

While the median P/E ratio for a stock in the S&P 500 has gone from 21 to 24 in the last months of 2024, EPS has basically gone nowhere (of course, companies need to actually report results, and there is a lag involved). Many times, earnings “catch up” to valuations due to the lag effect and justify paying a premium. However, we need to take into account that EPS is non-inflation adjusted, so the “real” numbers are even lower. But what if this time, the valuation expansion is simply a function of speculative activity based on Fed rhetoric? What if earnings don’t actually catch up to the same extent? That is the outlier scenario of our analysis.

We’ll get more insight into corporate financials once Q4 earnings season starts on Friday. But the risk of disappointment is high, especially since the Fed has enacted a puzzling reversal in policy. A tweet from WSJ’s Nick Timiraos sums up the “pivot”.

We obviously need to ask ourselves why the FOMC seems to have given up its fight against inflation. After all, loosening monetary policy via lower yields and higher stock prices would support higher inflation. The Federal Reserve must see a risk or a stress building up in the economy, in order to take this stance. And last Friday’s payroll data might offer some clues to what the risk is.

On the surface, we got a “hot” report, beating analyst estimates. The economy added 216K jobs (vs 150K expectations) and the unemployment rate was 3.7% (vs 3.8% expectations). However, if we take a look under the hood, this was a bad report that included downward revisions to previously published data.

First of all, the unemployment rate is misleading, since 676K people left the workforce in December alone. The labor force participation rate fell abruptly from 62.8% to 62.5%, artificially boosting the headline unemployment rate.

Going back to the original report, December’s 216K rise minus the 71K downward revisions to November and October yield a net rise of 145K, in effect missing expectations. In a troubling trend that’s pervasive as of late, 11 out of 12 labor reports in 2023 have been revised lower from original estimates.

In total, in 2023, more than 700K job gains have simply been revised away.

Finally, ~25% of job adds in December came from Government, not Private employers. This is an unsustainable ratio going forward, as the economy needs many more private sector employees to support government jobs via tax revenue. The ratio should hover around 5-1, not 3-1, as is the case right now. All in all, the employment report does not argue for a “soft landing”, and we can see why the Fed has become apprehensive about raising rates further.

Our Trading Strategy

Overall, we see limited upside for the equity market in the short term. There is a high risk of disappointment stemming from corporate earnings results and guidance. The December CPI report is due to be released on Thursday and could prove problematic even if it comes in below expectations (a much lower inflation print would signal potential weakness ahead). For the moment, running a portfolio on the defensive side makes sense, as we need to get a better understanding of the economic environment.

Technicals argue for a continuation of the recent losing streak and we need to see some solid support form before deciding to get more aggressive with our risk-on allocation. We believe that a better entry point is in the process of forming.

YoY headline inflation is expected to come in at 3.1% with core at 3.9%.

UnitedHealth, Delta Airlines along with finance majors JPMorgan Chase, Citigroup, Bank of America and Wells Fargo report results on Friday, marking the start of Q4 earnings season.

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