Going back 120 years, December has traditionally been a very good month for the stock market. Within the last 120 years the S&P 500 has been positive in December 73% of the time. The Russell 2000, which is the index for small cap stocks, has been up 87% of the time in December. This boost in the final month of the year is known to traders as the “Santa Claus Rally”. Should investors expect a Santa Claus rally in 2018 given the recent sell off in the markets? The answer may hinge on the results of the Federal Reserve Meeting on December 19th.
The Fed Decision
The fate of the Santa Claus rally may very well be in the hands of the Federal Reserve Committee this year. The Committee’s decision regarding the Fed Fund Rate could either cause the market to rally if the Fed decides to keep rates unchanged or it could push the markets lower if they decide to move forward with the anticipated quarter point rate hike. The Fed has a really tough decision to make this year. The goal of the Fed is to keep interest rates at a level that promotes full employment and a target inflation rate of 2%. In periods of economic expansion, it’s the Fed’s job to make sure the economy does not overheat which in turn could lead to prices of goods and services in the U.S. spiraling out of control.
Over the past few years, the U.S. economy has continued to expand and the Fed has been raising rates in quarter point increments. A very slow pace by historic standards. The Fed has already raised the Fed Funds Rate three times in 2018. What are the chances that the Fed raises rates again in December?
Solid Employment & Inflation In Check
The good news is there is not a lot of pressure for the Fed to raise rates in December. As of October, the unemployment rate sits at 3.7% and the employment data that we have seen throughout November has been strong. Historically, a strong job market usually results in higher wages for employees which is the main driver of inflation. So in the current economic environment, the Fed’s main focus is keeping inflation within its 2% target range. The Fed’s measuring stick for the rate of inflation is the Personal Consumption Expenditures Index. Otherwise known as the “PCE”.
There is a “Headline PCE” and a “Core PCE”. The Core PCE excludes prices for food and energy which is the Fed’s main barometer. Why does the Fed use Core PCE? Food and Energy prices can fluctuate significantly over short periods of time which can distort the results of the PCE index.
Below is a chart of both the Headline PCE and the Core PCE:
As you can see in the chart, the blue line that represents the Core PCE is right below the Fed’s 2% target. The PCE index is reported monthly and in October the PCE came in at a year-over-year change of 1.97%. Also you will see in the chart, due to the drop in the price of oil over the past two months, the Headline PCE is also dropping. While Headline PCE is not the Fed’s main measuring stick, there does seem to be a correlation between Headline PCE and Core PCE. It makes sense because regardless of the price of the product that you are taking a sample of, that product needs to be transported from the producer to the end user, and that transportation cost, which is largely influenced by the price of oil, will have an impact on the price of product within the Core PCE index.
This is good news for the stock market going into the December Fed meeting. With the Core PCE running just below the Fed’s target 2% rate and the Headline PCE declining, there is not a big push for the Fed to raise the Fed Funds Rate in December. I would even make the argument that raising the Fed Funds Rate in December would be a mistake.
The Fed & The Stock Market
The Fed is not a slave to the stock market. It’s not the Fed’s job to make sure the stock market continues to go up. Just because the stock market has experienced a large sell off over the past two months does not mean that the Fed will come to the market’s rescue and not raise rates. But remember, the Fed’s job is to keep the U.S. economy at full employment and keep inflation in check. Since inflation remains in check, it would seem that the prudent decision would be for the Fed to pause in December. If the Fed decides to raise rates in December, I have a difficult time understanding the catalyst for that decision.
Drivers Of The Recent Sell Off
It’s been a frustrating year for investors. Over the past 7 weeks, the U.S. large cap index, mid cap index, and small cap index have forfeited all of their gains for the year. International equity markets have been crushed this year. In a year like this, normally investors could turn to the bond portion of their portfolio for some support but that has not been the case this year either. The Barclays US Aggregate Bond index is down 2.38% year-to-date in 2018. It’s been a return drought this year with a double dose of volatility.
While the rapid rise in interest rates at the beginning of October may have triggered the market sell off, the downturn has been sustained by revisions to the forward guidance offered by corporations within their third quarter earnings report. While it has been another solid quarter of earnings for U.S. corporations, many of the companies that have been leading the bull market rally revised their forward earnings guidance down for the next few quarters. U.S. corporations seem to be embracing the uncertainty created by the trade wars and the tight labor market going into 2019.
It’s important to understand that as of today corporate earnings have not fallen short of expectations. As of November 14, 2018, 456 of the 500 companies in the S&P 500 had reported 3rd quarter earnings. 77.6% of those companies reported earnings above analyst expectations. This is above the long-term average of 64% and in line with the prior four quarter averaging of 77% exceeding expectations.
What really changed was the gross revenue numbers. Of those 456 companies that reported, 60.4% of those companies reported Q3 revenue above analyst expectations. That puts it in-line with the long-term average of 60% but below the average of the prior four quarters at 73%. While the U.S. economy continues to show strength, U.S. corporations have largely built an “earnings buffer” into their forecasts.
Economic Expansions Do Not Die Of Old Age
Everyone is on the lookout for the next recession. Each market sell off that we experience in this prolonged bull market rally makes investors question if they should run for hills. As one would expect, as you enter the later innings of an economic expansion the markets will begin to become more volatile. It’s easy for investors to hold their positions when the markets are going straight up with no volatility like 2017. It’s much more difficult to hold positions when it feels like you’re on a boat, in a storm, in the middle of an ocean. The temptation to try and jump in and out of the market in these volatile market conditions becomes much greater.
It’s very difficult to predict the future direction of the stock market using the recent fluctuations in the stock market as your barometer for future performance. If we look at many of the economic expansions in the past, we historically do not enter recession because the market calls it a day and just decides to go into a downward death spiral. In the past, there was typically a single event or a series of events that caused the economy to go from a period of expansion to a period of contraction. It’s for this reason that during these periods of heightened volatility that we rely heavily on the economic indicators that we track to determine how worried we should really be.
One of the main indicators that we track that I have shown you in previous updates is the Composite of Leading Indicators. It aggregates a number of forward looking economic and market indicators in an effort to provide a measurement of the health of the U.S. economy. See the chart below.
Each of the light blue areas shows when a recession took place going back to 1970. As you will see, in most cases this indicator turned negative before the economy entered a recession. If you look at what this indicator is telling us now, not only is the U.S. economy healthy, but over the past year it has strengthened. If you look at where we are now, there has never been a time since 1970 that this economic indicator has been at its current level, and a recession just shows up out of nowhere 12 months later.
We have no way of knowing what action the Fed will take on December 19th. However, given the tame level of inflation and the 3.7% unemployment rate, we would not be surprised if the Fed pauses at the December meeting which could lead to a health rally for the markets in December. Even if the Fed throws the market a curve ball and moves forward with the quarter point rate hike, while this move may seal the markets hopes of posting a positive return for the 2018 calendar year, the economy is still healthy, the probability of a recession within the next 12 months is still very low, and interest rates, although rising, are still at historically low levels. This economic environment may reward investors that have the discipline to make sound investment decision during these periods of heightened market volatility. The “easy years” are clearly behind us but that does not mean that the economic expansion is over.
Have a safe and happy Thanksgiving everyone!!
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.