Euphoria? Euphoria? http://www.federatedinvestors.com/mmdt/static/images/mmdt/mmdt-logo-amp.png http://www.federatedinvestors.com/mmdt/daf\images\insights\article\landscape-winter-colorful-small.jpg December 18 2020 December 18 2020

Euphoria?

It's not just Santa that has the market in a holiday mood.

Published December 18 2020

The Santa Claus rally seems to have started on cue, aided by a lot of Santa’s helpers. Shorts that are being squeezed hard and hedge funds that are their longest in years are providing ample fuel. So, too, is money pouring in from retail stock funds, along with a surge from Robinhood traders, a new factor in the market. Despite these huge post-election inflows and major indexes at all-time highs, year-to-date equity flows are a paltry $3 billion relative to fixed-income’s $300 billion. So, with more than $4 trillion sitting in the money markets, there’s still plenty of cash on the sidelines. A lot of the recent flows are going to formerly out-of-favor stocks. Long-term internals for the S&P 1500 Energy sector have soared to their best levels since late 2018—the percentage trading above their 200-day moving averages is a whopping 94%, now even higher than the broad market average. It’s been a long time since Energy trends have been this strong—it’s one of Fundstrat’s top sector picks for 2021. This reflects the consensus belief that growth will be strong next year. Even the Fed is forecasting real U.S. GDP to expand 4.2% in 2021, which if holds would be the best year since 2003, when the S&P 500 rallied 26%. U.S. stocks top Deutsche Bank’s survey of investors’ holiday wish lists, followed by emerging-market equities. (For last-minute shoppers, slippers were relatively popular!)

It is easy to see why equities are attractive. Stimulus keeps flooding in from all over, the earnings yield suggests the index is not historically expensive (especially as earnings forecasts continue to march higher) and the S&P dividend yield remains well above the 10-year Treasury yield (which has been stuck below 1%). To be sure, market sentiment has reached historically dangerous levels. The bullishness embedded in both an extremely low Chicago Board Options Exchange put-call ratio and wide AAII bull/bear spread represent big contrarian negatives, as does the “excessive optimism” reading in Ned Davis Research’s daily measure of trading sentiment. The record spate of SPACs (special purpose acquisition companies formed to fund yet-to-be-named IPOs) have raised a record $70 billion year-to-date and euphoria surrounding recent high-profile IPOs also are consistent with an environment in which investors ignore risks, often at their own peril, BCA Research observes. Other warning signs: the proportion of S&P names above their 50-day moving averages suggests the 6-week rally is nearing exhaustion. More crucially, the spot VIX is rising relative to the 3-month VIX, often an indicator of an imminent correction. Which is consensus, and therefore …

… it’s highly doubtful a pullback, if it comes, will be greater than 5% to 10%. Money is easy, vaccines are rolling out and despite some softening amid new Covid restrictions, key economic metrics remain solid (more below). Also, the earnings outlook keeps getting brighter—Goldman Sachs expects net margins to reach 11% in 2021, just shy of 2018’s record high. All of this is consensus. Is that necessarily bad? History reminds us the crowd generally is correct, except at turning points. Let’s not be a scrooge. The market is short-term overbought, but when the tape is this strong, corrections are more like consolidations than peaks. One of my Wall Street sources is a scrooge, describing valuations as being in wonderland. But today’s P/E multiple is nearly equal with levels at the start of the last three bull markets while the 10-year yield now is under 1%, versus 7.5% in 1992, 5% in 2002 and 4% in 2009. Drawdowns often are accompanied with internal weakness and that just isn’t the case today. Breadth is solid, with advancing NYSE issues beating declining issues by large margins. Seasonally, Santa owns the next few weeks anyway. Euphoria? Only if the earnings outlook is too bright. I believe.

Positives

  • Housing’s rally may last awhile Starts and permits jumped again—permits hit a 14-year high—and builder confidence slipped but remained historically elevated. By Ned Davis’ estimates, the U.S. is short about 3.7 million housing units as builders struggle to keep up with demand that’s being fueled by two longer-term trends: rising household formation rates as the largest-generation (millennials) ages and a surge in remote work that appears likely to remain after the Covid crisis eases.
  • A global synchronized recovery December’s flash Markit PMIs sent positive signals, with both the manufacturing and services sectors showing resilience. The eurozone composite index overshot expectations, coming in just shy of expansion, while the U.S. composite softened but was still a very solid 55.7. Evercore ISI’s trucking survey was elevated, with ports from L.A. to Long Beach to New York setting shipments records. In Asia, the OECD Composite Leading Indicator for China hit a 3-year high and ISI’s survey of China December sales surged, helping MSCI global indexes reach new highs.
  • Small rally shows healthy breadth With two weeks of trading to go, Q4 is on course to be the best quarter ever since the Russell 2000’s inception in the late 1970; Q2 ranks in the top five. Small’s outperformance over large the last three months is a 99th percentile event, exceeded only by early 2000’s relative surge.

Negatives

  • Consumers mired in wave 3 November retail sales disappointed, falling 1.1%, their biggest decline in seven months, as the Covid crisis cut into in-store traffic and online sales didn’t rise enough to offset the drop-off. Year-over-year sales still rose, but with more restrictions hitting in December, the worry is sales could disappoint again, particularly amid restaurants where the drag on outdoor dining will only worsen with the colder weather.
  • Manufacturing mired in wave 3 Surveys of manufacturing activity eased the Fed’s New York, Philadelphia and Kansas City districts, reflecting an expected slowdown that could carry over into the early months of 2021 before the full benefits of widespread vaccinations kick in.
  • Congress, do your job! Weekly jobless claims unexpectedly rose to a 3-month high, hastening talks in Washington on an aid package before the holiday recess. At this writing, a final deal had yet to be struck.

What else

I believe The gap between actual and consensus earnings in the quarter was the widest ever at 38%, with over two-thirds beating, another record. Earnings and sales forecasts are rising for Q4, and Jefferies sees the same for next year across segments, with earnings projected to rise 46% for small companies, 43% for midsized firms and 21% for large corporations. Compared to 2019, 2021 earnings are projected to be up a respective 4.8%, 2.2% and 3.5% across the three segments.

It’s been a good ride for bonds From 1990 to today, U.S. Treasuries and global equities have delivered equivalent returns of roughly 7.5% on an annualized basis. BCA Research says this means bonds have been the superior investment because of their significantly lower volatility. But it questions if bonds can match this performance going forward, given the 10-year’s low yield relative to where it stood 30 years ago at 8%. Over that period, two-thirds of bonds’ returns came from their income component.

Gaining weight this holiday? Bank of America shares that human-made materials outweigh the entire Earth’s biomass and of the total weight of mammals on the planet, 60% are livestock, 36% are humans and just 4% are mammals in nature.

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DISCLOSURES

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-market and frontier-market securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.

Investing in IPOs involves special risks such as limited liquidity and increased volatility.

Price-earnings multiples (P/E) reflect the ratio of stock prices to per-share common earnings. The lower the number, the lower the price of stocks relative to earnings.

Russell 2000® Index: Measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. Investments cannot be made directly in an index.

Small-company stocks may be less liquid and subject to greater price volatility than large-capitalization stocks.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

The S&P Composite 1500 Index combines three leading indices, the S&P 500, the S&P MidCap 400 Index and the S&P SmallCap 600 Index to cover approximately 90% of the U.S. market capitalization. The index is unmanaged, and it is not possible to invest directly in an index.

Stocks are subject to risks and fluctuate in value.

The American Association of Individual Investors (AAII) Bulls Minus Bears Index is a measure of market sentiment derived from a survey asking individual investors to rank themselves as bullish or bearish.

The Empire State Manufacturing Index gauges the level of activity and expectations for the future among manufacturers in New York.

The Federal Reserve Bank of Kansas City surveys manufacturers in its district monthly to gauge the level of their activity.

The Federal Reserve Bank of Philadelphia gauges the level of activity and expectations for the future among manufacturers in the Greater Philadelphia region every month.

The Markit Composite PMI is a gauge of manufacturing and service activity in a country.

The National Association of Home Builders/Wells Fargo Housing Market Index is a gauge of how well or poorly builders believe their business will do in coming months.

The Organization for Economic Cooperation and Development's composite leading indicators for the global economy are designed to provide early signals of turning points between the expansion and slowdown of economic activity.

VIX: The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility.

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