The stock market made a steady string of all-time highs in the first half of December. But equities lost their luster after the December FOMC meeting held on December 17-18. The news from Chair Jerome Powell was that the Federal Reserve Board was now anticipating two, not four rate cuts in 2025. This halving of rate cuts was not a surprise to us given the level of inflation and the strength in the economy, so we were surprised at how poorly stocks reacted to the news. However, the market’s response revealed how much investors were counting on easy monetary policy to support their equity holdings; and as we noted in December, it also disclosed the level of speculation in the stock market.
In our view, only speculators would rank Fed policy, and the number of fed funds rate cuts as the number one driver of stocks in 2025. In reality, the real fed funds rate has fallen from 280 basis points in August of 2024 to 160 basis points and this suggests that the current fed funds rate is already dovish. Rate cuts should be less important this year than the strength of the economy, the ability of the economy to grow jobs, and corporate America’s ability to produce profits. We would also place federal deficits at the top of the list of drivers for 2025. Nevertheless, equities weakened again this week after the JOLTS report showed job openings were greater than expected and the ISM nonmanufacturing index showed prices paid were significantly higher. This reaction to the price index exposes a growing sensitivity to potential inflation.
Market commentators are suddenly sensitive to inflation and the rise in the 10-year Treasury yield to 4.6%, which is a big jump from the 4.1% seen in late November, but still within the 3.7% to 4.9% range it has maintained since June of 2023. And strategists are suddenly worried about the comparison of the S&P 500’s earnings yield (earnings divided by the S&P’s price) and the Treasury yield. In fact, little has changed in recent history, and the trailing earnings yield (based upon S&P Dow Jones data) is 4% and the 12-month forward earnings yield is 4.6%. These have been the average for both earnings yields throughout 2024. However, when the dividend yield of 1.3% is factored in, the total forward earnings yield for equities is actually 5.9%. In short, little has changed in the last few quarters, equities remain competitive with bonds, yet market commentators are suddenly worried.
Equity valuation has been an issue for a long time, but the total expected return from equities continues to favor equities over bonds in our view. We think too many market forecasters are simply worried that fiscal and monetary easing will no longer be supporting equities. We, on the other hand, have been worried that fiscal and monetary easing were the drivers of equities rather than job and earnings growth. In our opinion, jobs and earnings are the two factors that will matter most in 2025.
This is why December’s job report this week will be important. There has been a disconnect between the establishment and the household surveys throughout 2024, and we will be looking primarily at the household survey for clues as to whether the job market is weakening or improving. The incoming administration has been working overtime on getting foreign companies to invest in the US and to grow the job market. This is a plus. And while newscasters are forecasting higher inflation in 2025 as a result of potential tariffs, it could be that the threat of tariffs is what will keep manufacturers in the US and entice foreign companies to invest here as well. If so, this will be good for job growth, household income, GDP, and corporate profits. Time will tell.
Good News?
Good news is a matter of perspective. Investors appear worried this week that job and economic growth will inspire inflation and increase interest rates. If so, this is exactly why the Federal Reserve should not be cutting interest rates! However, historically interest rates will rise as economic activity improves. This is fine as long as earnings also grow. From this perspective, stronger economic activity is a plus. And there were a number of good economic signs in recent days.
The ISM manufacturing index rose 0.9 points to 49.3 in December, with 8 of 10 components increasing in the month. This was favorable; the only outlier was employment, which fell from 48.1 to 45.3. The ISM nonmanufacturing index rose 2 points to 54.1, with six of 9 components increasing in the month. However, the biggest increase was in prices paid, which jumped from 58.2 to 64.4. This is the part that spooked the market this week. Order backlog fell from 47.1 to 44.3 and employment eased from 51.5 to 51.4. We are more concerned that both employment indices fell in December! See page 3.
After a long stretch of weakness in the housing market in 2022, 2023, and most of 2024, tiny green shoots appeared at the end of the year. The November NAHB confidence index had a big uptick in single-family sales expected over the next six months and the pending home sales index rose to 79, its best reading in nearly two years. This pending home sales uptick represented a 6.9% increase from a year earlier and sales were strong in most areas of the country with the exception of the Northeast. See page 4.
The housing cycle had been artificially boosted in 2020-2021 due to stay-at-home mandates issued during the pandemic; and this pandemic boom was followed by a housing slump in 2022-2024. But the housing cycle may finally be normalizing. New home sales grew 8.7% YOY in November, the best improvement in over a year. Existing home sales similarly rose 6.1% YOY, its best increase since June 2021. In both cases, the sales trends have been improving in recent months. The housing market will also be supported in 2025 by historically low existing single-family home inventory which fell to 3.7 months in November. See page 5.
Total retail sales picked up at year end, growing 3.4% YOY in November. Sales excluding motor vehicles & parts and gas stations were even stronger, increasing 3.6% YOY. What is most encouraging is that November’s unit sales of vehicles hit 17.0 million on an annualized basis, the best level seen since May 2021. Despite the fact that interest rates remain high, total vehicle sales were finally approaching their pre-pandemic levels at the end of the year. See page 6.
Dear Santa Claus
The market failed to have a Santa Claus Rally this year and market breadth has weakened. As a result, many prognosticators are turning bearish for 2025. However, at present, the charts of the indices do not reflect anything other than a normal pause in an uptrend. Only the DJIA and the Russell 2000 index have tested their 100-day moving averages, while the SPX and Nasdaq are trading well above these benchmarks. In short, the jury is still out on the recent market weakness which still appears to be a normal pullback. See page 10. The 25-day up/down volume oscillator is at negative 1.74, neutral, and down significantly from last week, and below an uptrend that has been in place since the October 2022 low. Since the October 2022 low, every oversold reading in this indicator has been met with solid bargain-hunting buying. In short, an important test may be on the horizon, and we will be watching to see if this indicator reaches an oversold reading and how long it lasts. An oversold reading that lasts more than five consecutive trading sessions is a warning and would be a sign that the bullish momentum that has been in place since the October 2022 low has been broken and a decline of more than 10% is on the horizon. In short, there are reasons to be cautious in the near term.
Gail Dudack
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