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Santa Claus Rally?

| December 06, 2023

There are many seasonal patterns and phenomena observed when it comes to the markets. This time of year, the one that gets the most billing is named after our favorite, white-bearded man in a red suit. Technically the Santa Claus rally is the final five days of the trading year and the first two days of the following year.

But it’s also possible that good old Saint Nick is coming early to the markets.

After a rough 3rd quarter, the markets rallied in November to put up one of the best months seen in quite a while. But better than just the ‘Magnificent 7’ doing well, the Dow Industrials did well, as well as small and mid-cap stocks. International stocks were strong, and even bonds shined.

In fact, the 20+ year treasuries bested the equity markets for the month of November.

So why is that? Let’s look at a few possibilities.

The FED met on November 1st for their regular six-week interval meeting. As expected, they left interest rates at 5.25%-5.50%. More importantly, their tone after the announcement was more dovish than the market was expecting. Though they still left on the table a chance of one more rate increase, they were also potentially suggesting that they may be done. Does that seem like a lot of hedging to you? Yeah, me too.

Now, the market has priced in five interest rate cuts by the FED for 2024. Let’s take a look at the FedWatch Tool.

You can see that it’s predicting an almost 60% chance of the Fed Funds rate being between 3.75% and 4.25%. That is roughly 1.25% lower than it stands today.

Because interest rates have “come down,” at least as far as longer-term rates, financial conditions have eased.

Interest rates are a big part of the financial conditions index, and you can see in the circle above how they have made conditions easier (below zero is easier, above zero is tighter).

But let’s look a little closer. Why would the FED cut interest rates? If the economy is humming along, there is no reason for them to cut rates. In fact, they might be more likely to raise rates depending on how good things are and the corresponding inflation levels (this would be the no landing scenario).

So, the only reason to cut rates is if the economy is slowing down. Is it slowing down? Good question, because if you listen to some of the talking heads, the 3rd quarter GDP was outstanding.

5.2%, that sounds great. No slowdown here! Correct, but remember, GDP is a lagging indicator. It’s only telling us what happened, not what’s going to happen. Think of a rookie shortstop who gets off to a torrid pace, hitting .380 in April and May. Is he likely to continue that pace through September? Possibly, but that early league leading pace doesn’t actually tell us anything about where he’ll end up. With that in mind, here is the GDPNow forecast from the Atlanta FED.

Keep in mind that this changes all the time. As new data comes out, the Atlanta Fed adjusts their forecast in real time. That being said, both the GDPNow and economists agree. Low 1% GDP is the forecast roughly halfway through the 4th quarter. Not stellar, and as pilots will say, it’s just above stall speed, meaning it’s easy for the plane (economy) to fall and go negative.

The Leading Economic indicators have been negative for a while.

Have the indicators hit bottom? Maybe. But they might also stay down for a while, like the 2001 recession.

We’ve talked about many other indicators, but most of note have been pretty weak for many months. Of course, Mr. Market has a way of moving around weak hands, either pulling them in or spitting them out, usually making them into the “dumb” money we refer to often (but not our preferred label!).

The unemployment rate is “up” to 3.9%. But Chris, you have said that historically anything under 5% is considered full employment. It is, but like most things, absolute numbers are less important than relative numbers. Unemployment has gone from 3.4% to 3.9%, which is not great, since usually the unemployment rate starts to tick up as we enter a recession. Keep in mind that we won’t know the date of the start of any recession until long after the fact (usually a year or so later).

So if the market is right and the Fed is going to cut interest rates, I think the only thing that makes sense is that the economy is in, or is soon going into, a recession. Then the question becomes what kind of recession? Mild, deep, severe? Severe recessions don’t happen that often and they are usually accompanied by something breaking in the system. We could get that, but it’s probably not the odds-on favorite as potential scenarios go.

A mild recession? That would be the best outcome, but I don’t think we would see the FED cutting rates by 125 basis points in that case. So, the market will probably have another temper tantrum because it won’t get the cuts they wanted. Remember, the market is sort of like a 2-year-old. It’s not pretty when it doesn’t get what it wants.

A moderate to deep recession? I think this one is most likely if the FED continues to raise rates, making an already somewhat weak economy even weaker. Then you would get probably more than 125 basis points of cuts from the FED because they are way behind the curve and run the risk of something breaking.

If I had to make a guess, I would say we are somewhere between a mild and moderate recession. Unemployment goes up to 4.5% or so, rates come back down, and inflation is back around that 2% level the FED wants. Nothing breaks and the FED finds a nice landing spot that we can get off the merry go round of interest rate hikes/cuts. Too much to ask? Probably, but one can hope.

Finally, we just got the JOLTS number today. That seems to be heading in the right direction. There are now roughly 10 jobs for every seven unemployed people. That is down from two jobs for every one unemployed person.

So unemployment is ticking up, the number of open jobs is coming down, leading indicators are still quite weak, but the best forward looking indicator (the stock market) seems to be holding in there for now. So much depends on how the next few months go and how the FED reacts to that. I say react, because the FED tends to follow the 2-year treasury. This is what it’s saying.

Going down since its peak in mid-October. It will likely drag the FED with them again.

That’s it for me today. I hope you have a great day. If you have any comments or questions, please feel free to reach out to us.