Market poised for Santa rally as near-term risks fade. Market poised for Santa rally as near-term risks fade.\images\insights\article\santa-bag-present-small.jpg December 17 2021 December 6 2021

Market poised for Santa rally as near-term risks fade.

Reiterating 4,800 and 5,300 '21 and '22 targets and value tilt

Published December 6 2021
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Today’s rally aside, stocks have endured a substantial correction in the last six weeks. Although the maximum peak-to-trough pullback in the S&P 500 was a relatively paltry 3.5% (and at this writing has gained half of that back), other measures of stocks' performance were far worse. Small caps got clobbered (the Russell 2000 entered 10% correction territory), emerging markets dropped 6%, bitcoin plunged 28% in the past month and many individual stocks we like in the value sectors also fell more than 10%. Market pundits have been scrambling to “explain” late November’s suddenly poor market sentiment, but let’s face it: we’ve come through a significant up move for over 18 months now, and sometimes a sharp pullback can be just what the doctor ordered to clear the decks and prepare for the next advance.

We’ll see if today’s rally carries forward, but even if fizzles, we believe as year-end approaches and investors refocus on setting up their 2022 portfolios, a Santa rally could be upon us. Next year’s outlook looks solid, with nominal GDP and earnings poised for strong advances, Fed policy error and tail inflation risks fading, fiscal policy tightening risks via tax hikes seemingly off the table, and the prospects for divided post-midterm government (always market friendly) rising. Even China could be about to chip in with a policy shift for the better. We think odds are good and (perhaps improved) that we reach our longstanding target of 5,300 on the S&P by this time next year. And who knows, as investors start to position for 2022 in the next three weeks, maybe Santa brings us a little something from the stock market for under the Christmas tree. Hitting our 4,800 year-end 2021 target may yet be in the offing.

Let's review the key worries behind the market's recent swoon and where we think these concerns could be heading:

  • Omicron likely to fade soon as a key risk Markets seem to be coming around to our less panicked view of this last mutation of Covid that spoiled Black Friday and the Thanksgiving holiday mood. Though we hardly are health-care experts, our work on Covid-19 suggests to us that we are now moving into the “endemic” phase: ever-changing mutations as the virus battles for survival by shifting to more contagious but less deadly formulations; ever-improving vaccine infrastructure to stay ahead of the latest mutation; and ever-improving therapeutics and treatment protocols to allow us all to go on with life and work through the endemic. We’d all love this to be over, but let’s face it, it’s not going to be any time soon. The good news is we are getting better and better at dealing with, and working through, Covid. This important lesson gets more deeply embedded in investors’ mindsets every time we overcome yet another “killer” variant. The confidence boost as we conquer omicron as the calendar turns to 2022 could be more fuel for the rally as winter moves to spring.
  • Fed policy error risk fading as well on Powell pivot Longer-term market investors such as ourselves were growing increasingly worried over the last three months that the Fed was missing the inflation risks in the economy. Down the line, that could have led to yet stronger inflationary forces and eventually, an economy-killing sharp hiking cycle compressed into a too-short time frame. So, we welcomed with open arms the Fed’s pivot last week and think most investors ultimately will as well. With real interest rates deeply negative, the Fed has plenty of hiking runway before policy turns restrictive. But by opening the door to three hikes in 2022 (now our forecast), the Fed can begin to let the steam out slowly. Inflation will still be high next year, but as investors consider 2023 inflation, the prospects of a downshift to something below 3% will seem plausible. This will allow the Fed to hike gradually through 2022 and 2023, supporting particularly the cyclical and interest-sensitive sectors of the markets.
  • Fiscal policy concerns declining With the worst of President Biden’s high tax-and-spend agenda now looking DOA, markets should cheer. The big tax hikes he initially proposed would have roiled markets and hurt earnings. Though the scaled-down bill likely will still be enormous and potentially worsen our already constrained supplies of both labor and goods, the scale of the negative impact looks containable and less worse than we’d feared. “Less worse” may be good enough once the final “Build Back Better” deal comes forth.
  • Midterm elections will soon come into focus, cheering markets. Generally, investors like divided government as it tends to force what little damage gets done by the politicians toward market/centrist policies. “Less is more,” so to speak. As the elections start to take center stage, what investors will begin to see is the rising prospects of a major Republican victory in the House and potentially a narrow Republican victory in the Senate.  With the president’s polls sinking, 2020 Census redistricting favoring red districts and the normal incumbent party losses in midterms—all overlaid with the Democrats razor-thin majorities in both houses of Congress—we expect a significant reversal of fortune for the GOP next year. As this becomes consensus, expect markets to view the coming election as a positive.
  • Does China pivot also? This may be the most uncertain of our fading risks—we have no particular insight beyond what we read and hear. But this weekend’s announcement of eased credit standards for Chinese banks could be the start of a better trend following the past year’s shift toward regulatory and monetary restrictiveness in the world’s second-largest economy, where huge sectors such as tech, education and entertainment have been hit. With China set to be on the global stages as Beijing hosts the Winter Olympics, Chinese leaders have a significant interest in making sure their economy is clicking. So here as well “less worse” seems likely from here. Market positive.

All the above remains against a backdrop of high single-digit nominal GDP growth this year and next, double-digit earnings gains, and a plethora of stocks valued fairly if not outright cheaply. The same cautious investors running for the hills over the past few weeks could soon be forced to jump back in lest the market run ahead without them again.

So, with a healthy correction behind us and news flow on what ails the market likely to grow less worse from here, Santa and his elves may very well be making an appearance soon. Make sure you leave out the milk and cookies for them.

Tags Equity . Markets/Economy .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

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Federated Global Investment Management Corp.