A Year-End Rally?

Doug Johnson CFA, Senior Investment Strategist

As we move into the final stretch of 2021, many investors are wondering if the market can deliver a holiday treat. One of the most common concerns we are hearing from clients this year is fear that a market correction is just around the corner. The reasons are many, but one common theme has centered around skepticism that the market can continue to defy gravity. While it is true the market has gone an abnormally long time without a significant pullback, the reality is that it doesn’t tend to follow any prescribed timeframe.

To be fair, not all concerns in the market have been created out of thin air. Elevated equity valuations, supply chain issues, inflationary pressures, and political brinkmanship are just a few examples of the challenges that investors have faced over the past few months. Yet, in the face of all these issues the market has looked the other way and continued its march higher. But what if the market isn’t ignoring the bad news, rather finding the good news?

The chart above lists several statistics for 3 major US stock indexes: S&P 500, NASDAQ, and Russell 2000. Naturally everyone’s attention goes to the first column with YTD performance numbers, but I believe the two columns on the right side tell a more important story. The third column from the left shows the percentage of stocks in the index with a least a -10% drawdown from YTD highs. Approximately 90% of all stocks in the respective indexes have dropped in price by AT LEAST -10% this year, with the Russell 2000 having 98% or almost the entire index suffer a -10% or more drawdown this year. The last column on the right displays the average drawdown from the YTD high. So not only have a large number of stocks experienced a decline of at least -10% this year, the average has been much higher. The average NASDAQ drawdown has been nearly -40%!!!

The unique insight here is that while everyone has been waiting for the “big correction,” it may have already happened under the surface as different sectors/styles have taken turns selling off while other parts of the index stood firm or even increased. This back and forth has allowed the indexes as a whole to stay relatively unscathed while the underlying positions have undergone a series of rolling corrections and price adjustments.

Why Do We Care?

So, what are some of the reasons a year-end rally could still be in the cards?

Stock Buybacks: corporations are still flush with cash and looking for ways to use it. Q2 2021 saw $199 billion in buybacks for S&P 500 stocks with Q3 trending towards $223 billion, which would be an all-time record. In addition, most buybacks are fairly price agnostic, meaning they aren’t waiting for big dips in the stock price to deploy cash, so it can certainly help accelerate high prices moving higher. Lastly, with a current Administration proposal to tax buybacks in the future, companies may feel some increased urgency to deploy as much cash as possible before new tax laws potentially go into effect.
Seasonality: we have all heard the adage, “sell in May and go away.” It isn’t just a clever limerick though, there is data to back it up. We have just exited what is historically the most bearish period of the year and entered what is historically the most bullish period of the year (Nov-Dec). According to Ned Davis Research, in years when the S&P 500 was up at least 20% through October (17 times including this year), the November-December median gain was 6% versus 3.4% for all years. In addition, the last time the S&P 500 was up 20% through October and was down the last two months of the year was 1943. Translation: stocks tend to go up at the end of the year, even when performance has been good during the first ten months of the year.
Retail Flows: while some may consider this a negative, it’s hard to ignore the level of retail participation during the current rally. This could be a little bit of a chicken and egg issue as well: are retail flows coming because the market is rallying or is the market rallying because of retail flows? It’s hard to say for sure which one came first, but if the rally continues then retail investors will most likely continue to put money to work in stocks. Retail option volumes are also exploding as investors are trying to leverage returns even further. This may eventually become a problem but for now, the music continues to play.
Earnings: according to the FactSet Earnings Insight report the blended earnings growth rate for the S&P 500 is 39.1% for Q3, which would mark the 3rd highest year-over-year earnings growth rate since 2010. While we expect the growth rate to decline over the next few quarters, it is still expected to be in double digit territory. When earnings are growing at such elevated levels, stock prices can certainly tag along for the ride.
COVID: I know; everyone’s favorite topic. The good news is the case counts, hospitalizations, and deaths have all been trending lower over the past months. In addition, several new therapeutic options have been released recently that have shown to be very effective at limiting the negative effects of contracting the virus. As more avenues become available to assist in mitigating the effects of the virus, this should continue to be a net positive for the market and will hopefully lead to an easing of supply chain issues across the globe.

Markets have certainly come a long way this year, but that doesn’t mean the party needs to end. The items listed above can provide the backdrop for a year-end rally, even in the face of well-placed concerns.

Weekly Focus – Think About It

“Life is 10% what happens to you and 90% how you react to it.”

Charles R. Swindoll

Market Activity

Performance last week for the four major asset classes were:

U.S. Stocks – Russell 3000 (IWV) – Gain of 1.78%
Developed Foreign Markets (EFA) – Gain of 0.69%
Emerging Markets (EEM) – Loss of -0.78%
Fixed Income (AGG) – Gain of 0.73%

(Note: performance is based on the change in price plus dividends)

Last Week’s Headlines

The Fed announced plans to begin to taper their asset purchase program by a rate of $15 billion a month, but were much less cautious on guidance around when rate hikes may begin. Powell stated the Fed still believed that inflationary pressures were “transitory” and they would be patient on rate hikes.
The US economy added 531,000 jobs in October. The most since July and the first upside surprise in three months.
The S&P 500 broke out to new all-time highs on the backdrop of strong macroeconomic data and favorable seasonality.

Eye on the Week Ahead

Key economic data points will include reports on retail sales, industrial production, and initial unemployment claims.

If you have questions about the recent market activity, please contact a member of HCM’s Wealth Advisory Team:

Disclaimer: Any tax or other advice contained in this document, including any attachments, is not intended and cannot be used for the purpose of avoiding penalties under Internal Revenue Code. No action should be taken on any information contained in this message without first consulting with your tax/legal advisors regarding the tax/legal consequences for your particular circumstances.

Additional Notes:

The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.
Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.
Past performance does not guarantee future results.
You cannot invest directly in an index.
Consult your financial professional before making any investment decisions.

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