Why the Santa rally in stock markets may just be a little late
- Richard Harris says the December rout in US stocks was, in hindsight, not surprising, given the market jitters and the languishing European and Chinese markets. Even so, the lower than average price-to-earnings ratio should reassure investors
All financial analysts have to make confessions from time to time. And I am man enough to grovel to my readers.
In mid-November, I confidently predicted the traditional Santa rally leading up to Christmas. It was as expected as a government denial of incompetence. A weak October and November indicated that investors would turn the tide and look to pick up some bargains before the New Year.
Instead, we had the biggest December rout in the markets since the Great Depression, with the S&P 500 falling by more than 10 per cent, before recovering to 8 per cent. The record for the worst December before that was a fall of 6 per cent in 2002. December is usually the best month of the year and, since 1950, they post an average rise of 1.53 per cent. Occasionally, we get it wrong.
In mitigation, the difference between success and failure can be very small. The known knowns were clear. US President Donald Trump’s trade tariff tantrums and China’s angry denials; his increasingly confusing tweetstorm against Federal Reserve Board chairman Jerome Powell; Iranian sanctions; and the monumental 40-odd per cent free fall of the oil price since early October were easily discounted.
The only problem our economy has is the Fed. They don’t have a feel for the Market, they don’t understand necessary Trade Wars or Strong Dollars or even Democrat Shutdowns over Borders. The Fed is like a powerful golfer who can’t score because he has no touch - he can’t putt!
— Donald J. Trump (@realDonaldTrump) December 24, 2018
The unknown knowns were not that obscure, either. How much is the Fed going to drive up interest rates before they are “normalised”, and what is normal? China’s tit-for-tat arrest of Canadian citizens – are visitors to China no longer safe? Why is US Treasury Secretary Steve Mnuchin calling the chief executives of the big banks – does he know something we don’t?
But, by far the most influential factor of all, which had not been discounted, was the unknown unknown that appeared in mid-November. That was when the market finally articulated that US economic growth was slowing.
Indeed, the wisdom of crowds had known about it for a while, as the falls had begun around October 1. The pent-up anticipation of the end of the sugar rush caused by the Trump tax breaks had surfaced and the markets could no longer see the way up. For, markets do not only seek economic growth per se but growth on economic growth. That incorporates the mysterious element of hope that markets use to price up shares.
Most other markets had figured this out sometime before the US. Europe peaked last November with an interim peak in May, and has since declined by 16 per cent. China peaked in January and has flopped by more than 20 per cent. It was only the stimulus of the tax cuts in the US that pushed US markets up against the grain.
I’m pleased to say that these moves once again prove “Harris’ Law of the Quarterly Change”, which states that market sentiment always changes at the end of a quarter (except when it doesn’t, which I admit limits its use as a predictive tool).
The US stock markets have finally given up the leadership, to perform more in line for the year with other markets. You can’t buck the trend forever. Note that those markets that had already fallen badly in the year have been protected from the worst in this last quarter, even if their direction of movement has followed that of the S&P 500.
The US’ first three quarters priced in a virtuous cycle of economic and earnings growth, now replaced by a vicious cycle of high share prices and disappointing news. It came at a bad time – when the markets are naturally slowing for the year end. Only the panicked or foolish trade after the second week in December. Liquidity is low and you can’t trust the prices. There were enough foolish panickers to push the markets down and the machines will have kicked in too, as algorithms programmed by teenage scribblers have never heard of the seasonal slowdown. Hence a big fall and a gnashing of teeth all round.
But the Santa rally may not be dead; it may just be sleeping. The S&P on a valuation basis is trading today on a share price-to-earnings per share ratio of around 16 times. Last quarter, it was 20 times; last year, nearly 22. This means you can buy at a low P/E, way below the 23 times average of the past 20 years.
Of course, we have to ask ourselves, “Does the market know something we don’t?” Even if it does, there is a great deal of downside protection. A serious fall in earnings (and, at most, we might expect a decline in growth, not a fall) could see P/E’s rise to 18-19 times without shocking.
When the big-boy traders return in the New Year, they are likely to guess that prices have sunk too far. So, if you were thinking of joining the selling rush; stay awhile. Santa might make a late call.
Richard Harris is chief executive of Port Shelter Investment, a veteran investment manager, banker, writer and broadcaster, and financial expert witness