With the U.S. midterm elections behind us, it’s time to return to the business at hand. U.S. economic data remain strong with the third quarter’s 3.5 percent GDP growth, signaling that the economy is doing pretty well across the spectrum. Net exports are strong, unemployment has fallen much faster than expected to a six-year low of 5.8 percent, and consumer confidence is at seven-year highs. U.S. retail sales for October were stronger than expected across the board, perhaps reflecting increased confidence, lower energy prices, and stronger employment trends.
With strengthening economic trends leading us into the all important holiday shopping season, will investors feel similarly buoyant? Over the coming months, a number of indicators will offer signals about how long this rally that began in 2009 can continue. One such indicator will be the so-called Santa Claus rally, which occurs in the week between Christmas and New Year’s Day. As the old adage goes, “If Santa Claus should fail to call, bears may come to Broad and Wall.”
Now that the anticipated seasonal pattern of higher volatility in September and October is largely fulfilled, I anticipate more positive factors over the next two months. In the prior 68 years, the S&P 500 has averaged monthly gains of 0.9 percent in October, followed by even stronger increases of 1.2 percent in November and 1.8 percent in December. If this anticipated seasonal strength—which is typically driven by an influx of cash into pension funds that their managers are keen to put to work—is not forthcoming, investors should seriously question how much further the current bull market can run.
One of my favorite indicators is the New York Stock Exchange Advance/Decline Line (NYSE breadth), calculated by taking the difference between the number of advancing and declining stocks on the stock exchange. The Advance/Decline Line, on a cumulative basis, has historically tracked closely with the Dow Jones Industrial Average Index and successfully predicted the peak of the stock market in October 2007.
CAN U.S. EQUITIES SUSTAIN THIS RALLY?
Despite recent DJIA all-time highs, the Advance/Decline Line remains 0.9 percent lower than its peak on August 29. Historically, a persistent divergence between the DJIA and the Advance/Decline Line often leads to a major correction in equities. Whether or not the Advance/Decline Line can catch up with the increase in equity prices over the next few weeks may determine whether the current rally is sustainable.
Abundant Accommodation
Overseas, the economies of Japan and Europe remain weak and policymakers face daunting challenges. The current dark cloud that hangs over Europe is a serious threat and something that investors should closely monitor. Interestingly, the slowdown in the euro zone is now concentrated at the core rather than on the periphery. The weighted average GDP growth in the core slowed for two consecutive quarters to 0.8% in the third quarter, while in the periphery it rebounded to 0.9% over the same period. As a result, we could soon witness a dramatic shift in the European political dynamic. If German politicians are worried about their own economy they will be more willing to accept accommodative European Central Bank policies than if the trouble spots are to the south.
CORE AND PERIPHERY REAL GDP GROWTH (YoY%)
Japan’s major increase in monetary accommodation surprised markets on October 31 and came just days after the U.S. Federal Reserve ended its own quantitative easing program. The night before the so-called Halloween surprise, I was looking over some Japanese data and thought to myself that it was surely inevitable that Tokyo increase accommodation and that doing it sooner rather than later would give them the added benefit of surprise. I never expected the announcement to come the very next day. The unexpected contraction in GDP in the third quarter put Japan into a technical recession, justifying the need for aggressive monetary stimulus from the Bank of Japan.
The takeaway from all this is that while the Fed has ended QE, the great global monetary expansion is far from over as other central banks take up the slack. The sell-off in U.S. high-yield bonds and leveraged bank loans during the third quarter has made for an attractive entry point, and while I expect to see some sort of consolidation in U.S. equities, my near-term expectation is that stocks are headed higher.
The United States will likely do very well in the next six months thanks to overseas policies, but there are obstacles ahead. As the U.S. dollar strengthens and without the support of the Fed’s asset purchases, the U.S. economy will be challenged heading into the second half of 2015 to sustain its growth based on employment and wage expansion. While it would be premature to draw conclusions beyond the first quarter of next year, for now, risk assets appear the place to be.
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