PMC Weekly Review – December 21, 2018

Can a Santa Claus Rally Save December and 2018?
Traditionally, the fourth quarter and December have been strong periods for equity returns. The surge in retail spending, the upbeat mood of the holiday season, and general optimism heading into a new year historically have carried over to the stock market, with a rally closing out most years. Since 1950, the S&P 500 Index has averaged its highest monthly gain in December, a 1.6% increase. Also, most of these gains have occurred in the final trading week surrounding Christmas and the New Year, in a phenomenon known as the Santa Claus rally. However, this December has proven to be an outlier, with the S&P 500 Index losing 13.6% in Q4 and 9.1% in December (thru 12/19). The Dow Jones Industrial Average (DJIA) is now on track for its worst December since 1931. As we prepare to enter Christmas week, let’s dive into what has been driving these poor results in December, and see if perhaps a Santa Claus rally can turn things around as we head into 2019.

First, let’s dig into the negatives driving the market lower, ones that would make Santa’s “naughty list” and lead to lumps of coal in Wall Street’s stocking. At the top of the list is the current trade war with China that has dominated the news cycle over the past few months. December began with President Trump and President Xi Jinping having a productive dinner meeting ahead of the G20 Summit in Argentina, one that was viewed favorably and resulted in a temporary ceasefire on tariffs. Since then, the likelihood of a trade deal or trade truce has deteriorated, with rhetoric marked by a highly nationalistic tone from both sides. The US government is on the edge of a government shutdown. In Europe, investors have been met with the challenges of Brexit negotiations, Italy’s budget standoff with the European Union, strikes and protests in France, and Europe’s overall economy failing to deliver on growth expectations this year.

Moving beyond geopolitical issues, an inverted yield curve (or short-term rates exceeding long-term rates) may have finally caught up with market participants. It is not the official two-year-over- ten-year reading. Instead, it is the yield on the three-year Treasury that surpassed the five-year Treasury yield on December 4 that spooked investors and led to a 795-point selloff on the DJIA. Fears that a recession could be on the horizon, which is typically foretold by an inverted yield curve, has pushed investors out of risk assets and into safer long-term Treasurys, driving longer-term yields even lower. This move out of risk assets is especially true for equities, which had benefited from ultra-low rates and highly accommodative Federal Reserve (Fed) policy for a long time. For the week ending December 14, investors pulled $39 billion out of equity mutual funds, according to data from Bank of America Merrill Lynch. Also, single-stock news has not been extremely positive for investors this month, including Johnson & Johnson (JNJ) dropping 10% last Friday, its largest one-day decline in 16 years, after it was reported that the company knew for decades that its baby powder contained asbestos.

Before running out of space listing the negative drivers, we should make sure we hit on some positive items for our “nice list.” The flipside of much of the selling pressure this fourth quarter, with most indices snapping into correction territory and more than half of S&P 500 Index companies now in a bear market, is that the market slide may be overdone. The “buy-the-dip” mentality has worked for investors on pullbacks since 2009, so it is fair to think that same strategy could continue to work going forward. Overall, US economic data continues to be positive, with strong readings on labor, manufacturing, and consumer spending. We are currently in the second-longest economic expansion since WW II, and GDP growth of 3% is expected for 2018. The Fed’s hiking of rates four times in 2018 (including Wednesday’s 25-basis-point increase) could be argued for either list. However, in trimming the forecast for two hikes in 2019 (from three previously), the Fed is providing a dovish tone, although perhaps less dovish than some would like, heading into the New Year. It also is important to note that the federal funds and short-term rates are at a near 0% real rate level. And finally, corporate fundamentals and earnings remain quite strong, companies are continuing with share buybacks, and capex is rising.

As the losses continue to pile up in December, it would be pretty shocking if even a monster Santa Claus rally could save December and 2018. However, as we prepare for 2019, it is important to keep in focus not only the negatives but also the positive drivers noted above, as these positives, for much of this year (and in previous years), have been able to outweigh and combat the negatives. Perhaps in 2019 we will provide Santa with a better list to work with. Happy Holidays!

Tim Murphy
VP, Senior Portfolio Manager

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