December has begun with a very inauspicious streak. If market action in December has felt odd, it is because it has been. Declining stocks have exceeded advancing stocks for 12 consecutive trading days from 12/2-12/17, a feat achieved only two other times since 1972, in October 1978 and May 1984. If Friday followed its opening action, it would have been 13 in a row. I bring this up as recent market action warrants additional perspective. That is the objective of this week's note. The bottom line is that the market entered the recent stretch on solid footing, so it is too soon to declare the two-year cyclical bull market over, and we remain overweight stocks, with a focus on large US growth companies, and versus bonds and cash. My second takeaway is that the market is entering its strongest seasonal period of the year. If the stock market cannot rectify recent breadth divergences in the next 10+ trading days, it would suggest our concerns about a more difficult 2025 could come to fruition.
The post-election rally was good, but not great, from a breadth perspective. On November 20, I had noted that almost every meaningful rally since 2009 have had bullish signals based on an extremely high percentage of stocks rallying together. Although this kind of December start is nothing new, the Santa Claus Rally tends to run from five trading days before through five trading days after Christmas. Below is a specific graphic that I wanted to focus on how the market has acted since this most recent rally that started in August to what it has done this past week. I do this so it is clear just how truly ugly this past week has been:
I would like to now zoom in my focus on the action of last week. The weakness mentioned in the beginning of this comment was an unfriendly backdrop going into the Fed meeting last Wednesday. I believe that this made Powell's comments even more destructive than if he would have made them during the throws of an upward bias. Why was this the case? Let's dive into the points of Powell's commentary:
- Fed commentary this time appears to be preemptive, not reactive. This is not normal and appears to be preparing for Trump rather than relying on data. This is very, very different, hence the unexpected move / statement by the Fed and subsequent unexpected move by the markets.
- Quarter point cut even though the US economy is still strong.
- Unemployment is still only 4.2%. Wages are still rising. Productivity is still strong. And GDP is over 3% and continuing a consistent advance.
- Longer-term interest rates (10–30-year maturity) continued rising. This tends to reflect strength in the economy and more fear of a rebirth of rising inflation.
The US Dollar is at its highest point since 2021, clearly not good for our exports. Foreign markets are in no place to be able to afford the increase cost of strong Dollar US exports. Larry Williams showed the income levels of the top states in the US and the weakest, and all of them are higher than foreign economies.
- Reflecting this income or purchasing power, see below the comparison of the US equity market to Europe, the Emerging Markets, Japan, UK, and Pacific Rim.
- Ultimately, this rise in US rates, further acceleration of strength in the US economy, further catalyzed by the Fed lowering rates, created an unexpected spike to new highs in US Currency. This created a shock to the markets much like the Japanese interest rate action earlier this year. What the markets like the least is what is not expected, particularly ones that create shock waves in currency markets.
- And if all of this isn't enough for further decline in the equity markets, Friday was the final "Quad Witch" of the year.
- Remember "never on a Friday" meaning the market does not usually bottom on a Friday. Instead, investors brood over their losses over the weekend and then come in ready to hit the sell button again on Monday. Only then do we usually get the beginning of a rally, often on "Turnaround Tuesday." That doesn't always happen, but it has happened enough throughout my career to take heed. Furthermore, Friday was "Quad Witch," and we are at the tail end of a very strong year, and it was estimated that $6.6 Trillion in options expired on Friday.
In order to see spatially how truly extreme last week's action was, another record was almost set. In the last 35 years, the second highest jump in the Volatility Index (VIX) was hit. This is how truly large this sell-off was. This means that investors were truly caught by surprise by Powell's comments following his rate cut. I liken this to the spike seen in the VIX seen when Japan surprise hiked their interest rates back in August. This again speaks to why I feel the most important mover of the markets is the currency markets as every institution is hedged to changes in currency values. So, if currency values adjust in an unexpected fashion, the end of the tail is the equity market, and the dog is the currency market.
Every time, 100% of the time, the market is higher 9 trading days after a VIX spike like this, and 3 months later it has been up 100% of the time a median of 9.4%, that corresponds to 6,600 on the S&P. This would be huge and would correspond to the targets that are being forecasted for the first half of 2025.
According to FundStrat, this VIX extreme point presents the third time this year that the S&P has previously and should this time, make a stand. It seems that most every year, whether markets are in an uptrend or a downtrend, markets have bounced. Looking at this calendar year, it can be seen below that since August there have been three almost perfect times to add capital to an equity portfolio. Again, it can't be assumed that this third time will play out like the previous two, I do like the fact that we are just now in the throes of the strongest two weeks of the year following this sell-off extreme:
A measure that is often used to signify an extreme is by measuring the percentage of companies on the NYSE that are above their 10-day moving average. I have highlighted in yellow below the lowest points this year when the 10-day hit an extreme on the downside. It is clear that the previous two were good points to commit capital. I want to qualify that this kind of indicator ONLY seems to be a high probability point when the market is in a longer-term uptrend. This time, last week, marked the lowest point of the three. If Santa intends to leave something better than coal under the tree, this could be a backdrop for a good Christmas rally in 2024.
In closing, the trick is to know how to identify when sentiment has reached an extreme and is reversing. Several surveys have reached what could be unsustainable levels. For example, equity ETFs hit their highest level in eight years. Critics of technical and sentiment analytics call my points above noise. What they fail to recognize is that data like market breadth and fund flows do not occur in a vacuum. Every day we see real-time reflections of how investors are interpreting information. Ultimately, fundamentals and macro-economic measures matter. That is why in our 2025 outlook, we highlighted earnings deceleration and inflation reacceleration as two of the biggest risks to our overweight equity allocation. Wednesday's FOMC adjustment to its inflation and policy rate expectations is a case in point. If inflation rises toward the 2.75-3.25% range next year, the bull market could lose one of its biggest propellers. But for now.....
Merry Christmas to all and to all a good night!
- Ken South, Newport Beach Financial Advisor
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