Major US stock indexes climbed to fresh record highs this week as the so-called ‘Santa rally’ picked up momentum headed into the final days of 2023. The S&P 500 rose over 1% on Tuesday to eclipse its previous peak, while the Nasdaq Composite also reached an all-time best.
Investor optimism has grown in recent weeks amid signs of cooling inflation and continued strength in the labor market. The growth streak comes despite lingering concerns over the economic outlook.
“There’s still quite the disconnect between the hard economic data – which points to a recession at some point next year – versus the buoyant mood in risk assets,” said Craig Erlam, senior market analyst at OANDA.
Strong Returns Cap Volatile Year for Stocks
The stock market has seen extreme volatility in 2023 amid high inflation, an aggressive Federal Reserve, and fears of an economic downturn. But the major indexes are now on pace to deliver strong annual returns thanks to the year-end Santa rally.
|2023 Return (YTD)
|Dow Jones Industrial Average
The market suffered steep declines earlier in December as economic data and comments from Fed officials indicated more interest rate hikes were on the horizon. But sentiment swiftly improved after November’s consumer price index (CPI) rose just 0.1% month-over-month.
“It’s all about the CPI print, that one CPI print changed sentiment,” said SoFi senior market strategist Liz Young. The tamer inflation “gave people confidence the Fed won’t need to be as aggressive.”
In recent weeks, the S&P 500 has broken through resistance levels that halted rallies multiple times this year, reflecting building optimism among investors. The index is now up over 5% in December.
Bets on Soft Landing Boost Risk Appetite
Market analysts say the Santa rally is being fueled by renewed hopes of a soft landing for the economy. This term refers to the Fed engineering an easing of inflation without triggering a painful recession.
The November jobs report showed payrolls grew by 263,000 while the unemployment rate held at 3.7% – underscoring labor market strength while lessening pressure on wages. Investors are betting these ‘goldilocks’ conditions mean the Fed can throttle back its massive rate hikes.
“People right now are trading optimism – it’s the hope trade,” said Victoria Fernandez, chief market strategist at Crossmark Global Investments.
Analysts say dip buyers have emerged to take advantage of cheaper valuations, underpinning the late-year ascent. The S&P 500’s forward price-to-earnings ratio has fallen from nearly 22 at the start of 2022 to around 17.
“Given easing financial conditions and better EPS trends of late, stocks don’t look particularly expensive, especially on a relative basis,” said LPL Financial’s Ryan Detrick.
Riskier market sectors like consumer discretionary and technology stocks that were hammered during this year’s selloff have recently led the charge higher on hopes that aggressive Fed policy will ease.
Uncertainty Persists Around Inflation, Growth
However, considerable uncertainty remains around the persistence of inflation and the economic outlook. Price increases have clearly moderated from 40-year highs, but core CPI rose more than expected last month.
“Inflation is heading in the right direction, but it’s probably still going to necessitate interest rates higher for longer than the market’s currently priced in,” said Seema Shah, chief global strategist at Principal Global Investors.
The probability of a recession occurring within the next 12 months still sits above 50%, according to work by the Cleveland Federal Reserve. Recent manufacturing data indicates the sector may be contracting.
Moreover, traders worry that diminishing liquidity with the holidays could exacerbate market swings. Low trading volumes near year-end raise the risk of swift sentiment shifts on any surprise headlines.
On the flip side, typical December seasonal tailwinds remain in play. Fund managers tend to buy into strength as they position portfolios going into 2024. Companies also engage in tax-related activities like buying back stock that provide support.
The Fed’s upcoming January policy announcement will be pivotal, as any hints of further large rate hikes would likely shake the risk rally. But for now, bulls are relishing the Christmas gifts being unwrapped each day.
“Who doesn’t like a good rally?” said Detrick. “Seeing markets at new highs gets people excited, and that can lead to a self-fulfilling prophesy of even more gains.”
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