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Issue 18: What to Make of Recent Rally in Equities?

February 6, 2023

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What to make of the recent rally in equities?

The ‘January Effect’ strikes again!
Especially for those on the sidelines, it’s been hard to miss a January rally that sent the NASDAQ up by 11%, its best start to a year since 2001. This performance brings to mind the well-known January effect: a seasonal phenomenon by which stock returns in January have historically been much higher than in other months. Wall Street practitioners had been aware of the pattern at least as early as the 1940s, but academics ‘rediscovered’ it decades later, when Rozeff and Kinney (1976) published a seminal paper—based on recently assembled databases of monthly stock returns—reporting that from 1904-1974, one-third of the total return delivered by NYSE stocks came from the month of January alone. Later research found that it was mostly small stocks that had performed badly in the prior year that drove the effect, suggesting it might be related to tax-loss harvesting: investors sell their losers in January to realize capital losses, driving down the price, which is free to bounce back in the new year. Other researchers have noted that the January effect actually pops up in markets all over the world, including markets without a capital gains tax, perhaps casting doubt on this explanation.


Stock market enters a Bizarro World
As we noted in our last Perspectives, year-to-date gains have been dominated by some of 2022’s worst performers, which is certainly consistent with the tax-loss harvesting hypothesis. That said, we too have our doubts about this rational explanation for the bulls’ behavior in 2023. One telling bit of analysis comes from Goldman Sachs, which put out some amusing stats on performance of companies the day after an earnings report, plotted below.

Figure 1 Median Excess Return vs S&P 500

While companies announcing a positive surprise have historically seen a bump in their price the next day, this earnings season a ‘beat’ has sent shares lower. Even more surprisingly, while firms reporting worse-than-expected results have generally sunk in the next trading session, this year companies missing their earnings have actually enjoyed a rally! Like DC Comics’ Bizarro World, in today’s markets, down is up and up is down. Of course, we wouldn’t advise loading up on companies with disappointing earnings—especially if the motivation is emotional FOMO after passing on the rally since October. Indeed, shrinking corporate profitability is one sign that the Fed’s actions are finally hitting Wall Street’s bottom line, making today’s valuations that much harder to justify at this stage in the cycle.

The Fed vs. Mr. Market

Investors just won’t take Powell’s word for it
The main event last week was the FOMC meeting, which concluded on Wednesday with a 25 bps rate hike, the eighth consecutive boost to the Fed’s policy rate. Markets briefly tumbled on the news, but soared higher after the press conference. The policy-sensitive two-year Treasury yield dropped 13 basis points as Powell was speaking, while the NASDAQ rallied 2% during the meeting and continued its climb on Thursday. Anyone who skipped the meeting and skimmed the charts might have imagined Powell turned dovish at the presser. Not exactly. Powell reiterated that a “couple” more hikes would be necessary and suggested that the Fed disagreed with markets on how fast inflation was falling and intended to keep rates high. Bullish investors apparently heard what they wanted to hear—i.e., ‘well, he didn’t rule out cuts’—and latched onto the Fed chair’s belief a soft landing is still possible, sending risk assets higher. Of course, the Fed has had messaging problems throughout this cycle, which is painfully apparent when one looks at US financial conditions overall since the beginning of 2022. Below we plot the Chicago Fed’s measure:

Figure 2 Chicago Fed National Financial Conditions Index

At this point, despite very aggressive tightening of policy rates, markets haven’t followed the Fed’s script. Actual financial conditions have been rapidly loosening since October, and are now essentially where they were back in April, just after the Fed began our current cycle of rate hikes. The ironic upshot is that by ‘fighting the Fed’, markets have increased the likelihood that if inflation doesn’t play out exactly as investors hope, policymakers will be required to act even more decisively, creating prime conditions for a hard landing.


As financial conditions loosen, job market tightens
The market loves reading the tea leaves in Fed communications. Did Powell do a poor job channeling his inner hawk to match the FOMC’s official statement? Perhaps so. It certainly doesn’t make the Fed’s job any easier when optimistic market sentiment works against the central bank’s policy agenda. Friday’s jobs report didn’t help, either, as nonfarm payrolls rocketed up +517,000—almost three times the expected increase of just +188,000! To make matters worse, that strong performance included a surprising jump in temp jobs, bouncing back from declines in November and December, which we highlighted in past Perspectives as a potential indicator of a real slowdown in labor. Investors have had fun with creative interpretations of the Bureau of Labor Statistics reports in recent months, too, and some may take solace in weaker wage growth. In the end, we believe the combination of an ultra-tight job market and uncomfortably loose financial conditions calls into question market expectations that inflation will plummet, investors’ perceived timeline for a Fed pivot, as well as increasingly lofty prices for risk assets. As such, we maintain our cautious stance.