So far, the Midterm script has played out rather well, with the market bottoming out in early October and then going on to post strong returns for October and November.
We turn our attention to December, the second strongest month traditionally, but during midterm years, the market trends are slightly weaker than normal.
This underperformance is more about the energy used up in the few weeks following the midterm elections than anything else.
From a market standpoint, December can be broken into two very different performance periods. The first ten trading days of the month are traditionally negative for all the indices. Again, some of this early weakness is caused by the overall strength we see in November, but a fair amount of this early-month weakness can be attributed to year-end tax loss selling by investors. Historically the market will chop for a few days before finally turning higher in the last two weeks as the Santa Clause rally kicks in.
The chart below shows the average performance of the major indices for December over the last 21 years.
If we follow this path again in 2022, one could anticipate the market making its December low around Wednesday the 14th, the same day as the December Federal Reserve meeting and announcement.
Granted, a lot of what the Fed communicates on the 14th will significantly influence the direction of the market, but history tells us to expect strength into the end of the month and year.
Rates & Dollars
The market experienced a nice rally off the midterm lows on October 14th (S&P 500); it cannot be overlooked that this rally also coincided with weakness in both bond yields and the US Dollar. While there have been good economic news and clear indications that we have seen peak inflation, it is still concerning that the market has only traded higher due to the inverse action of yields and the dollar. Since the October lows, we have seen the yield on the 10-year Treasury bond drop a little more than 10%, while the US Dollar has pulled back a bit more than 7% over the same period. 2022 has been a historic year for bond yields and dollar strength, resulting from the Fed’s very aggressive rate policy. As we head into the December Fed meeting, it finally appears that the Fed will reduce the size and pace of their rate hikes. A less aggressive policy will help remove the volatility associated with bond yields, the US Dollar, and equities.
It is always important to remember that the market can handle higher Fed rates and a higher US Dollar. Still, the quickness in getting to those higher levels has negatively affected the economy and the market overall. 2022 has been an unprecedented year of upside volatility for both bond yields and the dollar, upside moves we have not seen in generations. The yield on the 10-year Treasury has jumped from 1.52% at the end of 2021 to 3.70% at the end of November, a massive move higher. At the same time, we have seen the US Dollar rise from $95.67 at the end of 2021 to $105.49 at the end of November. Thankfully a lot of steam has come out of the dollar over the last two months as the Fed finally recognizes that the extreme dollar strength caused by their rate hikes is having severe effects on the strength of other global currencies.
It is impressive that the overall markets have been able to keep themselves together as well as they have. These Fed actions will remain important, but if the Fed begins to reduce and slow its rate hikes, other economic factors and data will take priority and begin to influence price actions. Markets can handle change; it is the speed of change that ends up causing significant issues. Thankfully, we appear to be past the maximum pain associated with both yields and the dollar.
Technical Backdrop
As it has been for most of the second half of 2022, many of our technical data points remain bullish and, in some cases, extremely bullish. For example, 376 S&P 500 stocks had positive money flows (strong late afternoon buying) as of the last day of November, a reading that is more than 40% higher than the daily average we have seen in the previous two and a half years. Again, money flow typically leads price action, so this strength should point to bullish market actions moving forward.
While S&P 500 money flows have strengthened over the last couple of months, our relative strength readings have consolidated for roughly five months.
That changed in November as we saw a massive spike in the relative strength of the individual names within the S&P.
At the end of November, 307 S&P 500 stocks had a positive relative strength position versus the S&P 500 Index. This is an increase of more than 40% during the month, one of the largest spikes we have seen. On a year-over-year basis, the number of S&P 500 stocks with positive relative strength was up more than 81%. This is a strong indication that average S&P 500 stock performance has begun to improve significantly and should be able to pull the market higher moving forward.
With the daily money flow and relative strength performance remaining bullish, we have finally begun to see significant improvement in the "daily new high" versus "new low" numbers across the market. Using the Dorsey Wright High Low Index for the New York Stock Exchange (NYSE), we have seen this index race from a multi-year low of 11% in early October to 58% at the end of November. This means we are not seeing nearly as many investments making new lows as we saw earlier this year, another bullish indicator showing that much of the selling pressure is out of the market. This type of positive action appears across several different markets and indicators, a clear example that strength is broadening in the overall market.
As we move into December, many technical indicators continue to paint a much more positive picture for the overall market. While we may continue to see volatility, eventually, these data points will matter and allow the market to work out of the malaise that has defined 2022 finally.
December Expectations
We are now in the home stretch of the race to the end of the year. Tax loss selling can affect December's performance. Traditionally, a down market will lead to more tax loss harvesting and an increase in window dressing from portfolio managers that want to shed the sight of poor positions from their books. This increase in selling can contribute to the weakness in the market typically realized over the first two weeks of the month.
Along with this selling, the market must deal with a new round of inflation data coming on December 13th, followed the next day by the final Federal Reserve meeting of 2022. Underlying trends continue to show inflation decelerating as we move into 2023. There is always a chance of getting an unexpected "sticky number." However, our base case for inflation is that it actually has peaked and could fall rather quickly in the coming months. This should help the Fed slow its pace and size of rate increases. Anything can happen when the Fed announces on the 14th, but expectations are now for a 50 basis point increase, down from 75 basis points, and commentary that the Fed will look to significantly slow their hikes in the new year. Very Bullish for stocks if this plays out as we are anticipating.
The most critical market data point we are currently focused on is that the midterm elections are behind us, and the market has entered into the historical sweet spot of the four-year presidential cycle. We will have more information on the historical strength of the pre-election year and much more in our 2023 Outlook. For now, let's hope Santa arrives with a big bag.