It's that time of year when investors want to believe in Santa, or at least his rally. But, given the sharp gains in the year to date, should they?
December is certainly a winning month. Since 1980, December has appreciated 26 times on the S&P 500 and declined just seven times. That is an 82% winning percentage, the highest winning percentage for any month on the S&P 500 for 1980-2012. Over that span, the S&P 500 has averaged 1.93% capital appreciation in December - also the best single-month performance.
Investors do not doubt that the market has done well in December. Their concern is that, given the 25%-plus appreciation in the preceding 11 months, will December 2013 be naughty or nice?
We always start with the historical precedent. We took a look at December performance following preceding 11-month periods in which the market rose in double digits. Since 1980, the S&P 500 has carried a double-digit gain into December 1st a total of 17 times. Those 11-month gains have averaged 19.7%. In those 17 Decembers that have followed a double-digit performance in the preceding 11 months, capital appreciation on the S&P 500 has averaged 2.6%, or 70 bps better than December average.
This December has not followed the script. Retailers in many parts of the country lost another prime weekend to the early snow storms. Also waylaid: Santa's rally, likely buried in a snow drift right off the Interstate. It is not too late for December to rally, and the S&P 500 is only down 1% for the month-to-date. But the market is running out of prime trading days, and volumes will soon thin out as traders claim "use it or lose it" vacation time before year-end.
Since 1980, the S&P 500 has had seven negative Decembers, the last one falling in 2007. Those negative Decembers have averaged a 2.3% decline, with the 6% pullback in 2002 being the worst of the bunch.
How do Januarys fare after a down December? The percentage performance since 1980 can be misleading, due to one big outlier month. On the S&P 500, the seven Januarys following the seven down Decembers since 1980 have averaged a 1.5% gain. Not bad, and better than the 1.07% average gain for all Januarys since 1980.
Keep in mind, however, that total average performance is distorted by the extraordinary 13.2% gain as of 1/31/87 from 12/31/86. If you exclude that one year, Januarys following down Decembers have averaged a 0.5% decline since 1980.
The Economy, Interest Rate, and S&P 500 Earnings
Meanwhile, we are looking for an above-consensus finish to 2013 in terms of U.S. GDP growth. As the year winds down, all investors are wondering about the outlook for U.S. GDP growth in 2014. The stock market has had a phenomenal run, and 2013 is now challenging 2009 as potentially the best capital-appreciation year during the multi-year bull market. For stocks to continue rising in 2014, the U.S. economy - chief driver of corporate profits - must continue to move higher and perhaps even accelerate.
Following the above-consensus revision to 3.6% growth in 3Q13 GDP, the Bloomberg consensus continues to forecast 4Q13 GDP growth of 1.9%. Economists, strategists and investors are forecasting 4Q13 GDP in an unusually wide range, signaling that they are not quite sure how to square a bunch of diverse inputs. On the one hand, the government shutdown and the fumbled Obamacare launch directly impacted business activity levels and sapped consumer confidence, respectively.
On the other hand, the economic data remains solid almost across the board. The ISM purchasing mangers' report for November reached 57.3, its highest level since April 2011. Both ISM manufacturing and services orders have increased for four consecutive months, usually a clear sign of industrial acceleration. On the consumer front, "Core" retail sales are up 4% year over year, while non-store (including internet) sales are up 9%. Consecutive months of 200,000-plus job gains and the very strong 3Q13 GDP reading argue for an accelerating economy into the new year.
Ironically, 3Q13 GPD strength is a key reason economists are wary on 4Q13. They fear that the prior quarter "pulled in" strength that would otherwise have contributed to 4Q13 GDP growth. Inventory accumulation contributed a significant portion of 3Q13 GDP growth, and some investors see that as an overhang. But inventory/sales ratios are well-behaved and lower than they were earlier in the year. Moreover, inventory builds tend to occur in multi-quarter clusters, rather than popping up one quarter and running off by the next. Argus is forecasting 4Q13 GDP growth in the 2%-plus range, and we would not be surprised by a reading north of 2.5%.
For 2014, Argus is forecasting 3.0% GDP growth, above the 2.6% Bloomberg consensus as of early December. A key component of our forecast include 3%-plus growth in personal consumption expenditures (PCE), after sub-2% growth in the middle quarters of 2013; consumer spending should be a more normal 70% of GDP in 2014. We also look for low- to mid-single-digit growth in non-residential fixed investment, a proxy for capital spending; a reduction in net imports, which are subtractive to growth, as energy costs continue to trend lower; and potential stabilization in government spending after several years of contraction. Although improved GDP growth is not a slam-dunk for 2014, we believe the conditions are good for economic acceleration next year.
Interest rates are creeping higher once again, as the consensus shifts to the view that even the Yellen Fed cannot withhold tapering forever. Interest rates peaked near 2.9% in August; we think the rate spike scared the Bernanke Fed into relaxing its tapering time-line. Then the government shutdown cut into business activity, prompting many economists to revise down their GDP forecasts for the fourth quarter. By 10/23/13, the 10-year yield had drifted down below 2.5%.
More recently, a range of positive data points from the consumer and industrial economies have caused rates to resume their move higher, and the 10-year yield is again above 2.8%. One new factor in the rate equation, in our view, has been signs of improvement in the European economies. This has accelerated the "flight from quality," as investors worldwide shift from fixed income to riskier assets.
While longer-dated maturities continue to sink in price, the short end of the curve is actually strengthening. Ten-year and 30-year Treasury yields are higher than they were one month ago. But three-month, six-month and two-year yields are all lower than they were one month ago. The expected new Fed chief, Janet Yellen, recently signaled her belief that short-term rates should remain ultra-accommodative for years to come, even if the pace of Fed bond buying begins to taper.
. Earlier this year raised our forecast for the 10-year yield range, from 1.75%-2.50% to 2.25%-3.25%. Long-term interest rates remain low compared to inflation. If there were a "normal" gap between inflation and the 10-year Treasury yield, the long bond yield would be closer to 4.0%. But we do not see the long bond at that level before 2015 at the earliest.
As we attain new inputs we continue to refine our earnings forecast for 2013. A close to final tally of 3Q13 calendar earnings indicates year over year growth of 5%-6%. We are expecting a strong growth rate in 4Q13, with earnings forecast to rise 9.1%. While that partly will be driven by economic acceleration, this year's fourth quarter faces an easy comparison against a year-earlier quarter impacted by a hotly contested presidential election, fears of fiscal cliff and sequestration, and (in the Northeast) Superstorm Sandy. All in all, we look for 4.9% growth, to $111 per share, in 2013; that is slightly better than the 4.6% growth recorded in 2012. As a reminder, Argus forward earnings estimates and growth rates are based against historical data on S&P 500 earnings compiled by Bloomberg. Standard & Poor's own accounting of its EPS numbers calls for 10.7% growth, to $106.25, for 2013.
Final earnings performance in 2013 will of course color our outlook for next year. Our current 2014 S&P 500 earnings forecast of $121.50 assumes stronger 9.5% growth in 2014. In order to reach our EPS target next year, many things must fall into place. Emerging economies - source of 25% of S&P 500 earnings - must translate encouraging purchasing managers' reports of late into real growth momentum in 2014. Europe must continue to heal; even if European growth is not great, the continent must avoid lurching from crisis to crisis, as it did in 2011 through early 2013. Asia must resume its growth leadership. And in the U.S., consumer sentiment and spending must continue to rise while the industrial economy revs higher.
After two years of mid-single-digit growth, high single digit or possibly low double digit EPS growth in 2014 would be welcome. EPS growth is required to keep valuation multiples from becoming too "stretched." Most important for an aging bull market, rising earnings support the bull case for stocks in 2014.
Sector & Major Index Performance
The major U.S. indexes as of early December were up on average about 500 basis points from where they were in early November - and that's after rising 400 basis points between the beginning of October and beginning of November! While the market surge Across October was of course fueled by the reopening of the government and avoidance of debt default, there is no clear catalyst for the even better performance across early November into early December.
The spread between the top-performing U.S. equity metric (the Nasdaq Composite) and the worst in this list (the DJIA) is 1,050 basis points. That would be more ominous for Blue Chip investors if not for the fact that the DJIA is up over 25% year to date. Consistent with a year-long theme, Wilshire Large Cap Value is 720 bps ahead of Wilshire Large Cap Growth for 2013 to date. Finally, bond investors have to be tiring of the moderately negative return in the Lehman U.S. Aggregate Bond index. Fairly soon, negative annual returns in the Lehman U.S. Aggregate Bond index will be lapping year-earlier negative annual returns in the bond index - and that might chase even more investors out of fixed income.
Market sector distribution shows more aggressive positioning since early November, as a few defensive sectors shrunk in size. On a month over month basis, three sectors - consumer discretionary, financial services, and healthcare - all added 30 bps since early November. We have long argued that investors mischaracterize Healthcare when they call it defensive; healthcare has a usage component that is highly economy-sensitive; and plainly healthcare has policy sensitivity. Despite the fumbled Obamacare launch, healthcare is at its highest weighting in this bull cycle at 13.3% of the S&P 500 market weight. Financial services, with a 16.3% weighting, is challenging Technology, with its 17.9%, for sector supremacy. And Discretionary, powered by rising incomes, low inflation, and improving sentiment, is now 12.6% of S&P weight - above its historical distribution band of 7%-12%.
Compared with one year ago, energy (down 80 bps) and consumer staples (down 90 basis points) are notably smaller, at 10.3% and 10.0% weights respectively. As rates rise, Utility weighting continues to diminish; utilities are now 3.0% of market weight, compared with 3.5% one year ago. Telecom services, another interest-rate sensitive area thanks to the sector dominance of high-yielding Verizon (NYSE:VZ) and AT&T (NYSE:T), is down to a 2.4% weight from 3.1% a year earlier. Consistent with monthly trends, three sectors - consumer discretionary, financial services, and healthcare - have all added over 100 basis points of market weight in the past year.
We pointed out that in terms of weighting within the S&P 500, several defensive and/or income sectors have shrunken relative to one year ago and even one month ago. What is hard to wrap your head around is how well some of these sectors are doing overall in the year to date. Energy and consumer staples, two sectors we called out as structurally shrinking on a sector-weighting basis, are both up more than 20% year to date. Utilities and Telecom Services, despite the shock of sharply higher interest rates, are each up more than 10% year to date.
The only way to reconcile good performance with shrinking weights for some sectors is for other sectors to be doing really fantastic - and that is precisely what is happening. Healthcare is up over 40% year to date, even though you would be hard-pressed to find someone who does not get a headache at the mention of Obamacare. Consumer Discretionary is less than a point below 40% total return for 2013, testament to the sea change in consumer spending, income and sentiment across this past year. Industrials and Financials are each up more than 30% year to date, even though the former is wrestling with strong dollar and the latter is hampered by weakening bank earnings.
On a month-over-month basis, the best sectors have been the index leaders: healthcare, discretionary, and financials. While it may seem odd for the entire market to be chasing strength, this is consistent with the year-end pattern in sharply rising markets, where lagging bears must furiously "window-dress" in hopes of closing the performance gap at least somewhat by year end.
In terms of global equity market performance, mature economies continue to dominate, trailed by resource economies and by emerging economies. As we saw in the U.S. markets, investors are chasing strength into year end. Thus, no market appreciated faster across November than Japan, which is now above 50% total return for the year.
The U.S. has delivered 29% total return, while the U.K. and the Euro Zone are providing high-teens total return year to date. Only because mature economies contribute so much of the global market weight, the DJ World index is also up in high-teens.
The resource economies have turned mixed, after moving in lockstep higher in the 2000s and lower across most of the current decade. Canada, up 11% YTD, has decoupled from Brazil and Russia, as these nations wrangle with inflation and deteriorating energy infrastructure, respectively. Resource economies could continue to struggle as long as the dollar tracks higher and will likely underperform at least until the dollar stabilizes.
As any double-digit capital-appreciation year winds down, lagging bears must chase the rally by "window-dressing" their portfolios with year-to-date winners. Bears and bulls alike believe this creates a virtuous cycle of further gains in December. January may be another story, but that's a month away.
Once everyone starts expecting a December rally, risks of a downtrend increase. Noted market strategist Yogi Berra captured this perfectly when he said, apropos of a favorite restaurant, "Nobody goes there anymore … it's too crowded." The bears continue to howl about the perilous market state, and that may prevent the December rally from becoming too crowded. Here's hoping those bearish howls carry across December and ultimately mix with victorious whoops from winning bulls welcoming in the new year.