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