This is an abbreviated market outlook for December, as we will be providing much more information in a few weeks with our 2024 Outlook.
Bond Market Finally Cracks
Prior to the turn of the century, it was the bond market that traditionally controlled the direction of the Federal Reserve. In the past, at each of their Federal Open Market Committee (FOMC) meetings, the Fed would adjust their rates to match the bond market. Today this dynamic operates much differently as it is the Fed and their rate outlook which usually sets the direction of the bond market.
For most of 2023, the Fed has painted a picture of maintaining rates at a higher level for longer than most expect, while threatening to continue to raise rates if inflation flares up again. This fear of additional action by the Fed has pressured bond yields in a significant way in 2023, especially since June, as we have seen the yield on the 10-year Treasury spike by more than 35% - levels not seen in decades. Thankfully in November this all-out assault on bond price reversed in a massive way and we finally got the extremely painful spike in bond yields to finally crack. As we have said before, the market can manage higher yields, but when the rate of change for yields is as aggressive as it has been over the last few months, it makes it exceedingly difficult for the market to function properly.
To gain an understanding of how powerful this reversal in the bond market was last month, we can look at the daily breadth data for the Total Bond Market, this is the difference between the number of bonds that traded higher vs lower in a given day. For the month, the daily average breadth for the Total Bond Market was +2,375, this means on average each day, there were 2,375 more bonds trading higher than lower. To put this into context, since the start of 2022, the average daily breadth for the Total Bond Market has been -554 issues traded. Also, the massive positive breadth seen in November was more than 1,000 daily advancing issues more than any month since the start of 2020. This positive breadth is a signal that liquidity is finally entering the market in a significant way for the first time in more than 2 years.
While we continue to expect yield to continue to fall over the coming months, we wanted to back test similar moves like we saw in November to help develop an expected market response move forward.
Specifically, we went back 5 decades and looked at the months where the yield on the 10 Year Treasury decreased by more than 10% on a month over month basis. Including this November, there have been 37 months since 1970 that saw the yield on the 10 Year Treasury decrease by more than -10% on a month over month basis. Below is a table that not only shows the historic data for those months the yield on the 10 Year Treasury decreased by more than -10%., but also the forward return of the S&P 500 Index in the 12 months following this reversal in yields.
Looking at the last 36 times we have seen a reversal in the 10-Year Yield as we saw in November, the forward return of the S&P over the next 12 months have been exceptional, averaging 16.13%. The positive rate is very strong as well – with only 4 negative S&P return years out of 36, or an 88.89% success rate. Of the 4 negative return years, the only significant drawdown was seen in 2007 & 2008, during the Great Financial Crisis.
The reversal in bond yields in November can help us draw two major conclusions:
1. Based on historical data, we are to assume that the return of the S&P 500 over the next 12 months should be above average.
2. The clock has started on when the Fed will begin to cut rates. We expect them to remain stubborn to keep inflation in check, but we are now past all expected rate hikes for this cycle and are moving closer to the Fed cutting rates every day.
December Market Expectations
The December market can be divided into two parts: early month weakness due to tax loss selling and second half strength as the Year End Rally begins.
Tax Loss Selling- throughout the first two weeks of December, the market traditionally deals with a bout of weakness as investors move to harvest losses to help offset previously realized gains. It is important to remember that in years where the market has been weaker throughout the year (such as 2022), investors should expect a larger negative effect associated with tax loss selling. Last year we saw the S&P drop by more than 6% over the first three weeks of December before rebounding slightly at the year end. We are expecting the effects of tax loss selling this December to be much more muted, which should lead to a stronger close to the month.
Year End Rally- the last two weeks of December are usually very bullish in nature and tend to be even stronger in years where the market has been trading to the positive side. This year-end rally leads into the Santa Claus Rally and the January Effects, both which the market observed at the start of 2023. Specifically, we are looking from the Russell 2000 to be the spark to start the year and rally. Typically, the small, capitalized companies in the Russell rebound the earliest, because most of the time they are the stocks sold for tax loss harvesting. This strength in the Russell continues through most of the first quarter of 2024.
Over the second half of 2023, the strength in bond yield negatively impacted many of our indicators, especially our Money Flow Indicators. Thankfully, the changes that took place in November have allowed Money Flow to work back to a neutral position from one of its lowest levels of the past few years. The rebound in this indicator is another signal to us that liquidity is returning to the market, which should allow the market to operate more efficiently. Again, liquidity is the life blood of the market. When it is strong, the market usually does not run into trouble.
Even though we are entering the month of December in a very overbought position, and we understand there is expected tax loss selling weakness ahead, we expect that December’s market at minimum should return its historical average of around 1.5%. Considering there are no significant issues facing the market or the economy at the end of the year – such as concerns about capital gains tax law changes, and the fact that liquidity has been returning to the market quickly – there is a chance that December will surprise to the upside.
In a few weeks, we will publish our 2024 Outlook and offer our initial expectations for the coming year. For now, we can enjoy the holidays and potentially the first few months of 2024 without too much worry.