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Expect a Massive Year-End Rally for U.S. Stocks

Last Updated September 23, 2020 1:15 PM
Jaimini Desai
Last Updated September 23, 2020 1:15 PM
  • There’s a good chance that stocks finish 2019 with a powerful rally.
  • Catalysts include positive seasonality, strong market breadth, bearish sentiment, desperate fund managers, and a more dovish FOMC.
  • Fear of recession and a poor outcome to the trade war have led investors to remain on the sidelines; both factors could now become tailwinds.

A powerful year-end rally in stocks is very likely. It would be fitting given that 2019 has been a sneakily strong year with the S&P 500 22.2% higher .

Market conditions are supportive, and there are a number of powerful catalysts including positive seasonality, underexposed fund managers, strong market breadth, bearish sentiment, and a more dovish FOMC in 2020.

S&P 500 YTD
The S&P 500 is up 22% YTD as of Nov. 2, 2019.| Source: stockcharts.com

Positive Seasonality

Seasonality Chart
Seasonality chart for average pre-election year and average year (1950-current).| Source: LPL Financial

This chart from LPL Financial  shows a tendency for stocks to have a year-end rally also known as a Santa Claus rally. This is even more pronounced in pre-election years.

When stocks gained more than 20% by the end of October, it resulted in positive gains in November and December 13 out of 14 times. Essentially, bullish seasonality is compounding on top of each other.

Year-End Rally Stats

Underexposed and Under-Invested Fund Managers

YTD Hedge Fund Performance
Hedge Funds are under-performing relative to S&P 500.| Source: Morgan Stanley QDS, Hedge Fund Research

Given this reality, underexposed and under-invested funds could become forced buyers. According to a report from Hedge Fund Research , the average hedge fund is up 4.9% over the first three quarters of the year. Fund managers who under-perform their benchmarks are at risk of losing investors, and even their jobs.

Fund managers are underexposed to equities due to reservations about the economy or odds of a successful trade deal but may have to buy anyway to not fall further behind their benchmarks. This dynamic is the fuel behind some of the most infamous Santa Claus rallies in history. Money managers in this position are desperately waiting for prices to come down. A year-end rally is their worst nightmare. This is the max pain trade.

Strong Market Breadth

Breadth is a measure of the stock market’s performance by participation. Currently, stock market breadth shows that participation is strong. This can be seen below in the chart of the NYSE Advance/Decline line on a cumulative basis , which has steadily climbed to new highs all year.

Cumulative NYAD 1Y breadth chart
Breadth chart showing stock market remains in accumulation mode.| Source: stockcharts.com

Another reflection of high participation is the number of stocks across a wide variety of sectors making 52-week highs following strong earnings reports. Some of these include retailers like Walmart and Home Depot, homebuilders, and big banks like JPMorgan. Compare this to previous highs in July and September, when gains were led by defensive sectors like utilities, REITs and consumer staples.

Bearish Sentiment

Bearish sentiment prevails despite the stock market making new highs. This is due to the media and the public’s obsession with recession .

Google Trends 'Recession' Chart
Google trends chart showing news articles mentioning the word “recession.” | Image : Sentimentrader, Bloomberg

Parts of the U.S. economy linked to manufacturing, agriculture and other export-oriented sectors have slowed. Money has moved to the sidelines or the short side in fear of these issues tipping the broader economy into recession. This is evident from the following chart of fund flows and investor sentiment :

Equity vs Bond Flows
Money moving out of equity funds all year.| source: Marketwatch, EPFR Global, BoAML
AAII Bullish Sentiment Chart
AAII bullish sentiment remains neutral despite stocks making new all-time highs.| Source: Bespoke Investment Group, AAII

There are signs that manufacturing may have bottomed. Forward-looking indicators like stock prices of cyclical companies, new orders and depleted inventories are perking higher. This is consistent with an upturn in the business cycle, which would lead to an acceleration in economic growth.

Sentiment surveys and fund flows indicate that investors are not positioned for such developments. Gains could be significant on the long side over the next two months as sentiment normalizes or even turns excessively bullish as it tends to do when asset prices top.

New, More Dovish FOMC

Another bullish development is that the Federal Open Market Committee (FOMC) is going to get even more dovish next year. Case in point: Kansas City Fed President Esther George and Boston Fed President Eric Rosengren have voted against raising interest rates. Both will become non-voting members in 2020. One of their replacements will be Minneapolis Fed President Neel Kashkari, effectively trading two of the most hawkish members with one of the most dovish.

The Fed’s window of possibilities in 2020 is to cut or hold interest rates. It won’t whipsaw markets by starting to hike after dramatically cutting rates all year, eroding its credibility and put it in the midst of a nasty election season. Recent efforts to bolster liquidity in funding markets are another bullish signal that it remains vigilant.