SPY: Is a Correction on the Horizon?

Throughout 2023, the U.S. stock market experienced several micro-cycles. From January to July, the SPDR S&P 500 ETF Trust (SPY), which tracks the performance of the S&P 500 index, advanced over 19% on a total return basis. However, in late October, nearly half that momentum had withered, with the Index briefly plunging into correction territory, indicating a 10% decline from July's peaks.

The rising bond rate between late July and October contributed to the recent correction. The three-month period provided an adequate opportunity for investors to pivot away from stocks. Adding to the investors’ worries was Chair Jerome Powell’s comment: “The question of rate cuts just doesn’t come up.”

October witnessed the weakest performance in the S&P 500 since 2018 – its third successive month of contractions. This decline was perhaps predictable, considering the economic forecast concerns, stubborn inflation rate, prolonged apprehension over Federal Reserve policy rates, and geopolitical turmoil.

The financial picture brightened in November when stocks rallied robustly, nearly restoring the S&P 500 to its July peak. Making an impressive rebound in just 16 sessions, the S&P 500 effectively exited its correction phase, marking the swiftest turnaround since the 1970s.

As evidence of an overheated economy finally began to cool, investor tension eased, and the S&P 500 got a significant boost, surging by 8.5%. This surge brought its progress close to a 20% year-to-date increase, coinciding with the 10-year Treasury rates plunging below 4.5%.

Furthermore, another lower-than-expected inflation reading offers a flicker of hope that the contentious battle against inflation might soon abate.

As the Thanksgiving holiday curtails November's U.S. trading week, investors are waiting to see if this resurgence in the stock market will endure until year’s end.

So, is the pathway clear?

While drawing definite conclusions could be too soon, let’s look at some promising indications suggesting the rally could persist until the close of the year…

After the Fed’s 20 months of stringent monetary policy tightening, it remains unclear to officials if the financial conditions are sufficiently restrictive to control inflation – a rate seen as surpassing the central bank's 2% target.

Despite this uncertainty, the Fed maintains interest rates within the expected range of 5.25%-5.50%. Chairman Jerome Powell has not dismissed the possibility of further monetary tightening, leaving markets to ponder possible future actions of the Fed.

Forthcoming economic indicators will primarily guide decisions regarding future rate hikes. Depending upon inflation trends, there is potential for introducing interest rate cuts during the second quarter of 2024 or the following months.

If the Fed successfully facilitates a "soft landing" for the economy, implementing rate cuts while avoiding a recession, this could potentially set off a stock market rally. Conversely, investors might encounter unexpected skepticism if economic growth continues at its current pace and inflation returns in the following months.

Consumer spending is paid attention to, which, till now, has been crucial for sustaining economic growth amid climbing interest rates that often lead to economic slowdown. Historically, November has proven to be a strong month for the S&P 500, with an average yield of 0.88%, making it the third most lucrative month.

Historically, the S&P 500 recorded positive returns 68% of the time during Thanksgiving week, an achievement exceeding the average week. The sales recorded during Thanksgiving and Black Friday act as a barometer of market sentiment. Strong retail figures may herald the beginning of a robust shopping season, potentially boosting stock prices.

U.S. consumer spending accounts for about 70% of the economy. However, core U.S. retail sales registered a marginal increase of just 0.2% in October as higher borrowing costs and persistent effects of inflation curbed spending, leading to struggles for retail stocks. An uptick in sales could lay the groundwork for a December rally.

Displaying a notable robustness, the U.S. economy has continued to grow at over 2% annualized pace in the first and second quarters of 2023, surging to a 4.9% annualized growth rate in the third quarter. There is additional optimism as the GDPNow forecast for the fourth-quarter GDP has been revised upward to 2.1%.

Favorable economic circumstances like a robust employment market coupled with a resolute trend in consumer spending have contributed significantly to the sustainability of this positive economic momentum. Corporate earnings, too, reflected optimistic trends in the third quarter, a sign that economists regard as propitious.

Analysts are hopeful for a mildly favorable turn in earnings moving forward. While current economic metrics remain somewhat subdued, they do not signal an impending recession. Consequently, the equity market remains a scene of active engagement.

However, should investors be more cautious? Quite likely. Let’s understand why…

This year's most optimistic occurrence was when the small-cap stocks in the Russell 2000 significantly eclipsed the returns of the SPY. Especially notable is the seemingly undervalued status of the small-cap index, which further intensifies with prospective Fed’s interest rate cuts scheduled for the first half of 2024. Historically,  debt-heavy small-caps perform well during Fed-induced rate reductions. Consequently, small-caps could potentially witness a significant boost as investors begin to speculate on the completion of the Fed's interest rate hike cycle.

The sign of an assuredly bullish market is the heightened risk appetite, funneling investors toward smaller, growth-oriented companies. This pattern aligns with the traditional long-term advantage of small caps over large caps, an edge not witnessed in recent years.

However, certain risks continue to loom. Most significantly, small-caps' vulnerability to recessions.

Despite Russel 2000’s attractive valuation, large-cap stocks have carried on their ascent while small caps are again underperforming, sparking questions regarding the genuine bullish nature of this market.

SPY’s promising gain offers encouragement. This arises from the fact that it's challenging to maintain a confident bullish stance when all the gains are primarily accruing to the so-called ‘Magnificent 7’, previously known as FAANG. These stocks have mainly driven the market-cap-weight gain in the S&P 500 in recent years, leaving the rest of the stock and bond market on the sidelines.

Over the past year, one prevalent error among investors was underestimating the potential rise in price-to-earnings multiples, particularly for large-cap and mega-cap stocks like those comprising the ‘Magnificent 7.’

Furthermore, the era of viewing stocks as the sole viable investment option has waned. For the past two years, investors have experienced attractive returns through bonds or even by allocating a portion of their portfolio to a money-market fund, with several offering yields exceeding 5%.

Bottom Line

Within just three weeks of November, a significant shift occurred — from initial skepticism about the bull market's validity to witnessing its first correction and ultimately seeing the S&P 500 Index rise to a new historical peak. A swift recovery saw stocks rise again, erasing the memory of the recent correction.

Every sector within the S&P 500 Index closed in positive territory, with more cyclical and economically sensitive industries leading the charges. This demonstrates the enduring expansion and robustness of the bull market, which, up until recently, has primarily been propelled by the strong performances of ‘Magnificent 7.’

With the current bullish trend and the anticipated positive impact of the holiday season, stocks could maintain their rally, even reaching previous high levels.

Bank of America Corporation's strategists suggest that due to U.S. companies' resilience in dealing with higher rates and macroeconomic disturbances, the S&P 500 is on track to reach a fresh peak in 2024. Meanwhile, RBC's projection for the SPY's EPS in 2024 stands at $232, indicating a promising trajectory for additional gains in the coming year.

However, the existing price of the index appears to already factor in the expected recovery in the SPY's forecasted EPS for 2024. Therefore, it may not be sufficient to drive the index's growth at this year's remarkable pace. It should also be noted that potential factors like a recession or emergent political or geopolitical unrest could pose further complications. Therefore, investors should tread with caution.

Lock In Now Before It's Too Late

I’ve been shopping for brokered certificates of deposit, and the rates between one-year and five-year CDs aren’t a whole lot different. Rates at my broker range from 2.4% for one-year to 2.65% for five, with two- and three-year rates in between.

My first inclination was to stay short. Why lock up my money for five years when I can get nearly the same rate for one, two, or three years? What if rates go up in the meantime?

Fat chance. Given the Federal Reserve’s past behavior, the odds of that happening are pretty slim, if nonexistent. It may make more sense to lock up your money – if you don’t want to risk it in the stock or bond market – for as long as possible now.

With all of the betting now on the Fed cutting – not raising – interest rates this year, market interest rates are only likely to go down from here, not up. Despite its recent track record of quick monetary policy reversals in the face of market volatility, shifting from a restrictive policy to a more accommodative one – i.e., lower interest rates – just makes the Fed more comfortable. Other than savers – who most people with any influence ignore – everyone loves low rates, and if nothing else the Fed wants to be loved. Continue reading "Lock In Now Before It's Too Late"