December 1, 2023
The recent rally in equity markets in response to a peak in bond yields is normal/expected. Lowering the risk-free rate in a discounted cash flow (DCF) valuation model always gives you a higher terminal value. The +9.6% gain in the SPX during November makes more sense when you consider the 70bp drop in 10-year bond yields was the largest since 1985. The DCF model requires the analyst to make assumptions about the risk free rate and future cash flows. A lower risk free rate usually reflects slower growth in the future, which could impact your cash flow assumptions. Forward-year SPX EPS estimates were largely unchanged through November with the rally only reflecting the impact of a lower risk free rate. Bond yields have peaked in our opinion, but higher yields that follow outsized Treasury issuance or lumpy macro data is still the biggest near-term threat for equity markets. And slowing growth that comes with reduced out-year estimates is the second biggest threat. Next Friday’s Jobs Report is the catalyst to watch.
Momentum reversal at year-end is one of the most consistent patterns in equity markets. This used to occur in January as investors bought back the positions sold for tax reasons in the prior year. The effect favors YTD underperformers at the expense of YTD outperformers. Academic publications still refer to the pattern as ‘The January Effect,’ but investors got wise to the trend about 20 years ago and it’s now been pulled forward into December. The momentum reversals actually started earlier this week, helped by supporting growth and inflation data. Investors started rotating out of mega-cap Tech on Tuesday and into areas like regional banks and office REITS. This year, almost everything should work with the exception of mega-cap Tech. On an index level, the momentum reversal usually favors the EuroStoxx 50 (SX5E) over the S&P 500 (SPX) for example. It happens every year and usually exhausts itself by the second week of January at the latest. The fact that it started earlier this year should mean it will end earlier.