Market Momentum Overpowers Gloomy Vibes

The economic news of the last month reminds us of Goldilocks.

Not too hot, not too cold, just right.

Unemployment is down to 3.7%, near 60-year lows. Inflation over the past year was 3.1%, getting closer to the Fed’s target. Oil prices are near one-year lows.

Still, people don’t feel like it’s a good time economically.

Is it the negative financial media? The nasty political environment? The geopolitical risks? Or are the vibes just off?

Because the data doesn’t back up these feelings.

In the past two years, there have been so many signals warning of economic downturns that didn’t pan out. An inverted yield curve, falling profits, and a stock market correction did not lead to the doom many called for on financial TV. We would argue most are not worth listening to anyway – they have no skin in the game on their economic or financial calls.

When the history books are written, we think the 2022-23 economic period will be called a mid-cycle slowdown. Recession it is not.

Companies are still hiring people. The demand for goods and services is strong. Households have enough money to keep spending. GDP grew at 5% in the third quarter and is tracking close to the 2% trend in the fourth quarter.

A common question we are getting is: how did the S&P 500 rise 16% from the October lows to be up 25% year-to-date?

1. The Fed changed its tune. The same day the market bottomed on October 27th, the inflation data for Personal Consumption Expenditures came in lower than expected. The Fed met the next week and remained on hold for the second straight meeting – this was the end game to interest rate hikes (though no officials came out and said it at the time). At the meeting in December, the Fed confirmed the 2024 outlook and added one more interest rate cut to the forecast. This is really in line with history, as the Fed cuts interest rates on average seven months after the last interest rate hike. Lower rates mean less interest expense for companies, especially small caps. The fact that the Fed made a U-turn after the mantra was “higher rates for longer” matters.
2. Too many people on one side of the boat. Markets fell 10% from the July highs to the October lows. This reset investors’ sentiment toward the market, causing many to worry about a further decline in prices. When everyone has already de-risked, then a small shift can turn the tide.
3. Fast twitch traders. Big institutions that use quantitative models have the quickest trigger on Wall Street. Data-driven decisions by Managed Futures strategies have just under $400 billion in assets. These funds seek to follow trends. If it’s up, buy. If it’s down, sell. The news does not matter at all. When the trend changes, their job is to get on the trend. UBS estimated that the week ending December 7th, these funds bought $30 to $40 billion of global equities, doubling their exposure.
4. Seasonally strong times. The fourth quarter tends to have a positive bias. Money managers who are behind chase names higher. With higher momentum, hedging desks need to keep buying to maintain neutral exposure. Lower volatility means funds that target a certain level must buy even more to support the target exposure. This momentum in action plays out like Newton’s first law of motion: an object in motion tends to stay in motion.

A naïve portfolio of stocks and bonds is now overweight in stocks relative to the long-term target. This occurred across institutional investors like endowments or foundations along with household portfolios.

This is even more true of the investor disciplined enough to rebalance or get overweight stocks in 2022. We could see some rebalancing back to targets over the months ahead.

As we turn the page to next year, we will continue to watch the data – not just the vibes. We know many factors can affect short-term moves in markets, but the fundamentals win out over the long term. This keeps us focused on what we can control when it comes to both down and up markets: our investment process.

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