This week in the markets: the S&P 500 reaches a new all-time high but without conviction as investors question whether the 2023 Santa Rally went too far too fast.
It has been a long wait. After 106 weeks, just over two years, the US stock market has limped over the line to hit a new all-time high. No-one is really celebrating, though. Given that the market tends to rise over time, new highs come along quite frequently and there is a distinct lack of momentum behind the latest move into uncharted territory.
The S&P 500 index closed at 4839.8, just clearing the high reached in January 2022. But it has taken three weeks to rise the 1.5% required to take the market over the line. Most of the work was done in the nine consecutive weeks of gains – 16% in total – at the end of last year when investors became excited – perhaps over-excited – about the prospect of significant rate cuts this year and next.
Although the market capitalisation-weighted S&P 500 has hit a new record, the equal weighted index remains below its peak, and the Russell 2000 small cap index is 21% down on its all time high. In fact, today’s set up of a bull market for the market’s biggest stocks at the same time as the small caps are stuck in a bear market is unique. This type of divergence has never happened before, even if is not unusual for some kind of a lag before market a market rally broadens out.
More interesting is to think about what might come next. If you look at previous all-time highs after bear markets or significant corrections, the odds are stacked in favour of a continued positive market. In most cases the market is significantly higher two years later than when it first reaches a new high. In 1985 it went on to rise another 50% at its maximum in the next two years. In 1995 it was 60% up at some point in the following 24 months.
There are exceptions, and double-digit declines do happen. But there has only been one major double-dip downturn in recent decades and that was during the financial crisis when the market fell another 52% after the 2007 high. The balance between good and bad outcomes is firmly skewed to the positive side so that is one reason to feel optimistic going into 2024.
But the rally continues to be driven by a small handful of stocks. The question is when and if the rest of the market will join in the Mag 7 focused rebound. Usually it does, but the lag can be long. Often more than a year or so.
As has been the case for a long time, the key driver of the market is interest rate expectations. The reason the market has run out of momentum so far this year is a change in the narrative from extreme optimism about rate cuts to a more nuanced picture. And that has been driven by new economic data on jobs and inflation. Prices rose faster than expectations on both sides of the Atlantic in December. In the US jobs growth and retail sales were stronger than expected. Over here, it’s a bit more mixed with retail sales disappointing but wage growth still high.
That’s resulted in a scaling back of interest rate expectations. In December, futures markets anticipated a 90% chance of a first cut in rates in March. Now the probability is around 50%. Despite changing forecasts about the start of the easing cycle, however, it is still thought likely that the Fed and Bank of England will cut rates substantially this year and that the US will avoid a severe recession. A Bank of America survey showed just 17% think there will be a hard landing for the economy and only 3% think interest rates will be higher in a year’s time.
A key change since the turn of the year has been on the geo-political front with attacks on shipping in the Red Sea raising fears that the war in Israel and Gaza could spill over into a bigger regional conflict with important economic implications in terms of the oil price and the cost of imports if containers are forced to take a longer route around Africa on the key routes between Asia and the east coast of America.
Other uncertainties arise on the domestic political front, with the latest developments in the year-long run-up to the US election making it look increasingly likely that Donald Trump will be the Republican candidate in November’s election. This week Ron De Santis dropped out of the race and Trump’s main rival Nikki Haley is well behind in the polls ahead of this week’s New Hampshire primary.
A victory for Trump is neither a good or a bad thing from a market perspective as was demonstrated in 2017 when the first year of his first term in the White House delivered market-positive tax cuts and defied the sceptics. But in terms of geo-political uncertainty, it points to more volatility ahead for the rest of this year.
When it comes to the other key driver of markets – company earnings – it’s business as usual as we move further into the fourth quarter results season. So far only around 10% of leading US companies have reported on the final three months of 2023 but it’s been a good start. Nearly nine in ten companies have beaten expectations by an average of just over 8%. That’s par for the course and suggests that the earnings cycle really did turn up last year. Whether forecasts of double-digit earnings growth this year and next remain plausible remains to be seen.
For now, investors remain cautiously optimistic about 2024. It would have been implausible for the end 2023 rally to continue for long into the new year. For one thing, the competition from alternative investments like bonds and cash has intensified in recent weeks as the sharp drop in yields during the Santa Rally has gone partially into reverse.
That’s been particularly the case over here where an index of UK government debt has fallen back by 3.6% as bond yields have risen again in anticipation of a slower drop in interest rates than was hoped for just a few weeks ago. Again, the pause for breath in bonds is unsurprising. Gilts, like US Treasuries, rose sharply in November and December.
However, the direction of travel for interest rates remains positive. Traders still think that there will be 1.1 percentage points of cuts here in the UK this year with interest rates falling from a 15 year high of 5.25%. That’s less than the 1.73 percentage points of cuts forecast at the end of last year. The reining in of expectations is unsurprising when you consider the stagflationary backdrop in the UK with wage growth still running at 6.5%, well ahead of the overall inflation rate, but weak retail sales pointing to a slowing economy.
In practice the UK’s higher inflation rate may prove short lived if, as expected a fall in utility prices in April see the CPI fall here to less than the Bank of England’s target of 2% as soon as the spring. Capital Economics, a consultancy, forecasts that the 10-year gilt yield will fall from its current level of nearly 4% to 3.25% by the end of the year.
Interest rates are back on investors’ radars this week as the European Central Bank and the Bank of Japan both announce their first decisions of the year. In neither case is any change expected. Christine Lagarde, the head of the ECB said at Davos last week that the first rate cut in the eurozone would likely come in the summer. The Bank of Japan remains firmly in a supportive mode, out of step with other developed world central banks.
Other key economic data this week include fourth quarter GDP figures in the US and the latest set of purchasing managers index numbers right across the G7.
But the main focus this week will be on company results. The Mag 7 are in focus via Tesla and there is a flood of other leading companies reporting, including: American Express, Netflix, American Airlines, General Electric, Johnson & Johnson and Procter & Gamble over the pond; and Associated British Foods, Foxtons, Wetherspoons, Wizz Air, WH Smith and Fever Tree over here.