Stocks are set for a year-end Santa Claus rally as the stars aline in the short term. First and foremost, the US economy remains on strong footing. This was confirmed on Friday when the jobs report showed a healthy 250,000 jobs were added and unemployment remains at a 49-year low of 3.7%. At the same time, wages showed a robust 3.1% growth year-on-year.
That’s good news for fourth-quarter earnings as consumers will have money to spend. A strong economy and robust corporate earnings growth will facilitate a healthy Santa Claus rally to close out the year.
Indeed, data from 1950 to 2017 confirms as much. The Stock Trader’s Almanac found that the S&P 500 Index advanced in 49 Decembers and declined 17 times. Moreover, the average gain of 1.6% is the best for any month.
Accordingly, odds are that we’re headed for a recovery in stocks in the short term. However, things get dimmer longer term.
Stocks to Struggle Next Year as Interest Rates Rise and Economy Slows
Rising interest rates are the strongest headwind the US economy has faced in over a decade. The Federal Reserve has raised rates 11 times since the end of 2016 to 2.25%. That might not sound a lot but it’s going to be a rude shock to borrowers and investors.
Indeed, the rise in the Fed rate is spurring the rest of the Treasury yield curve higher. That’s ominous for stocks because the “risk-free” Treasury notes are used to price consumer and business loans. That means when Treasury yields go up, the cost of borrowing for consumers and businesses also goes up.
Rising interest expenses can eat away at economic growth. Indeed, rising interest rates have triggered virtually every recession since World War II. A slowing economy (or recession) can take a huge bite out of the stock market.
Additionally, the 10-year US Treasury yield is used to discount cash flows and price other financial assets. Subsequently, a rise in the 10-year Treasury yield can pull down stock prices as their future cash flows become less valuable. In a sense, Treasury yields are effectively a crystal ball of sorts for the stock market that portends trouble in the long term.
Moreover, the benchmark 10-year Treasury yield has already surged from 2.32% to 3.19% over the last year. Many analysts now expect this yield to rise to 3.5% in the short-term and blow past 4% long-term.
As that happens, the stock market will re-price lower. The S&P 500’s price-to-earnings (PE) ratio is currently 43.6% above its historical average. This lofty PE ratio will come down and pull stock prices down with it. That means stock prices are likely to fall in the medium term.