The National - Will investors be gifted an end-of-year Santa rally?

Vijay Valecha, Special to The National November 15, 2022

In every bear market, investors repeatedly call the bottom too soon. It’s human nature to seek light in darkness, especially when there’s money to be made.

We should, therefore, treat any suggestion that we have now touched the bottom with caution.

With that proviso, there are reasons to be optimistic that the recent market bounce may point to brighter times. Now could just be a good time to go shopping for stocks before they become more expensive.

Investors who like to buy at the very bottom of the market may just have missed it, with the US S&P 500 up 10.24 per cent in the past week. Given that it is down 17.45 per cent year to date, it still has room to grow.

It jumped 5.54 per cent in a day last Thursday, as Wall Street celebrated an unexpected piece of good news: US inflation came in notably lower than expected.

Consumer prices rose by “just” 7.7 per cent in the year to October, down from 8.2 per cent in September (and 9.1 per cent in June).

This offered markets “a welcome shot in the arm” as it suggests the US Federal Reserve may take a less hawkish view on interest rate rises, says Joshua Mahony, senior market analyst at online trading platform IG.

Markets had expected the Fed to increase rates by 0.75 per cent for the fifth successive month in December, but are now pricing a 73 per cent chance of a 50-basis point rise.

“Whether that slowdown in tightening will maintain a prolonged period of upside for stocks remains to be seen. But it has certainly lifted hopes of a festive end to the year for investors,” according to Mr Mahony.

History suggests the bottom of this year’s bear market is near, David Henry, investment manager at Quilter Cheviot, says. In the past nine years, the sell-off lasted on average 315 days. Today’s has now run for just over 300 days, making it the longest since the global financial crisis.

“Historic data suggests investors need to hold their nerve or miss out on a strong recovery,” Mr Henry says.

“The average performance on the day after the market bottom is 3.2 per cent, with one month returns at 14.2 per cent and the six-month figure at 30.4 per cent.”

There is always the risk that markets will fall even further, especially given the amount of bad news out there, but buying a little too early is often better than leaving it too late, Mr Henry says.

“Trying to time the bottom is a fool’s game and you are likely to miss out on the best short-term returns, which tend to occur during periods of maximum pain.”

Ignore the pervading economic gloom. Bear markets typically end while the recession is only just getting going, as investors are forward-looking.

“We don’t even need good news for markets to turn, just better than expected,” according to Mr Henry.

There are still plenty of things for investors to worry about, including the war in Ukraine, energy prices, yet more Covid-19 lockdowns in China, and the impact of higher living costs and mortgage rates on consumers.

The recent rally was largely in stocks that were previously oversold and selling pressure could easily resume, says Fawad Razaqzada, market analyst at City Index and Forex.com.

Cryptocurrencies have sold off sharply after troubled exchange FTX blocked withdrawals, sending Bitcoin to a year’s low.

“This could affect risk appetite across wider financial markets,” he says.

Inflation is not beaten, either.

“We have seen energy prices come down slowly, but this has been offset by rising food and shelter prices,” Mr Razaqzada adds.

October may have been the best month for US stock indices in more than a decade, but this does not mean investors should flick a switch from bearish to bullish, says Chaddy Kirbaj, vice director at Swissquote Bank Dubai.

“The S&P 500 remains down by 18 per cent year-to-date, while the Nasdaq is down 15 per cent. One month is not enough.”

He blames the October rally on investors rushing to buy the dip, on the assumption that the Fed would slow the pace of rate rises next year.

Yet, “the underlying risks remain intact” and geopolitical risks are still “considerable”.

“Lower interest rates alone are not enough to bet on the rally, so we wouldn’t consider the gains in October to be a recovery,” Mr Kirbaj says.

Instead of shares, a better opportunity may lie in government bonds as the interest rate cycle approaches its peak.

Yields could start falling in 2023, and bond prices will rise.

In contrast, the mighty US dollar is showing signs of weakness. It has risen 12.3 per cent this year against a basket of currencies, but dropped 5 per cent in the past month as investors anticipate a more dovish Fed.

The greenback’s correction will be “slow and gradual”, Mr Kirbaj says, but demand for major currencies such as the euro and Swiss franc is likely to gain momentum next year.

If China finally reopens after the coronavirus, commodity stocks could benefit, too.

“Yet, we still think markets are not fully pricing in all of today’s risks,” Mr Kirbaj adds.

There are reasons to be cheerful, too, as Europe has now topped up its natural gas storage facilities, making it less vulnerable to threats from Russian President Vladimir Putin.

Prime Minister Rishi Sunak appears to have steadied the UK and in another positive, Christmas is coming, says Vijay Valecha, chief investment officer at Century Financial.

History shows that stock markets typically perform strongly towards the end of the year, a phenomenon known as the Santa rally.

The S&P 500 has posted an average annual gain of 1.6 per cent in December since 1950, according to the Stock Trader’s Almanac, making it the best month of year.

The US political calendar also plays a part, with the S&P 500 typically falling 17.1 per cent from peak to trough during the mid-term election year, Mr Valecha says.

“On average, the index rallied around 32 per cent over the next year.”

In another sign that inflation could be on the run, a key indicator called the Manheim Used Car Value Index has fallen for five months in a row, and has plunged a record 10.6 per cent in total this year.

Everything now depends on the timing of the Fed pivot, Mr Valecha says.

“If the Fed funds rate stays high, a liquidity crisis is highly likely. The FTX fiasco could just turn out to be one among the many. The resulting recession also could turn out to be a prolonged one.”

As ever with the stock market, there are reasons for optimism and pessimism, but the positives seem to be building up.

The best-performing sectors over the past 60 days were industrials, financials, consumer staples, materials and health care, Mr Valecha says.

This suggests they could lead the way when the recovery finally comes to an end. Investors who want to play this trend could consider buying a low-cost exchange-traded fund (ETF) that tracks a spread of companies.

The Health Care Select Sector SPDR, Financial Select Sector SPDR Fund and Consumer Staples Select Sector SPDR Fund offer some exposure to the recovery without taking on too much risk, Mr Valecha says.

“I would only invest in riskier sectors once there are clearer indications of a Fed pivot. We aren’t there yet, but it’s getting closer.”