The S&P 500 finished the month of March last week at 2,834.40, rising by 1.79% and recording a perfect first quarter (i.e., advancing in all of January, February, and March). A lot has changed since my last post at the end of January, but the relentless advance in the price of the S&P 500 is not one of them. Today’s close at 2,873.40 leaves the index just 1.99% away from its all-time high closing price at 2,930.75. It appears almost certain the index will trade up to new all-time highs at some point in 2019. What’s more uncertain then is whether or not the price of S&P 500 will then stay there. As I think about “where are we now?”, I keep coming back to the idea of strength into the summer, turbulence at some point over the second half of the year, and fresh new all-time highs (again) in early 2020.
Strength into the summer is mostly driven by everything we’ve seen thus far in 2019 - there’s tremendous upside momentum and a complete and total lack of selling pressure. There’s also bullish pre-election year seasonality over April through July (more on this below).
The concern about the second half of the year stems mostly from the price action in the federal funds futures markets, combined with a recent tendency for the S&P 500 to struggle the latter portion of pre-election calendar years.
Fed Update: Rate Cuts Are On The Way
I shared this same table in my post from January (click here to reference), so this is definitely something that’s changed drastically since then. The Fed’s pivot in 2019 is rather astounding, and participants in the federal funds futures markets are now pricing a nearly 40% probability of a -25 basis point cut to the federal funds rate at any of the Fed’s meetings in September, October, December, and January of 2020. At January’s close, we were roughly -9% away from all-time highs with very low probability of rate cuts. Now, we’re -2% away from all-time highs with relatively high probability of rate cuts. That doesn’t add up, fundamentally speaking.
Cuts is plural because participants are also pricing in a near 20% probability of two -25 basis point rate cuts to the federal funds rate by January of 2020, or a -50 basis point rate cut at the January 2020 meeting. Broadly speaking, it’s logical to expect the Federal Reserve to cut interest rates in response to growing recessionary fears. Whether the rate cut is in reaction to a realized downturn in economic activity, or an effort to be proactive and stave off the possibility of a meaningful downturn in economic activity, both illustrate the Fed’s fear of a meaningful downturn in economic activity. They’re expected to take action on that fear in Q3 or Q4 of 2019. You almost can’t help but wonder what happens to the price of the S&P 500 if they don’t cut rates in Q3 or Q4. I can’t even imagine the President’s Twitter timeline.
Ironically, this is likely a contributing factor as to why the S&P 500 continues its linear advance to the upside - the Fed of the future is easier than the Fed of the present (you can replace Fed with any central bank). If the last three months teaches us anything, it’s that the “Fed put” or “central bank put” is alive and well (i.e., participants will eagerly bid risk assets today when the forward-looking central bank expectations of tomorrow are rapidly ascending). Now remember, the S&P 500 is notorious for getting excessively drunk late cycle. In other words, as the primary trend is nearing its transition from up to down, the index’s vision forward-looking isn’t exactly 20/20 - it’s usually blurred from intoxication (see October 2007 and September 2000’s swing highs). It’s also important to recognize that the “Fed put” or “central bank put” probably doesn’t last forever. A good sign that this chapter of market history is behind us is when you see price action like Q4 2018 - without a subsequent price rebound like we’ve seen in Q1 2019.
Pre-Election Year Slowdown in Q3 & Q4?
We’re all aware that pre-election years are historically some of the sunniest skies for the equity markets. However, each of the last three pre-election years have struggled over the August-December time period. I find this fascinating because this is mostly where the market is pricing in rate cut expectations with fairly decent conviction, so perhaps they’re forecasting weakness in economic fundamentals in the third quarter.
The table below illustrates the S&P 500’s forward returns from March’s close during all pre-election years since 1950. We can identify that it’s mostly smooth sailing April through July with the S&P 500 closing the month of July above March’s close 16 out of 18 times for median returns of 4.67%. With March’s close at 2,834.40, this would target a July close at ~2,966. That would leave all the bullish studies that I shared in my post from August of 2018 based on the S&P 500’s closing price in July in a positive light, which certainly appeared unlikely in December of 2018 (click here if you want to reference back).
We can then see things have taken a turn for the worse from August through December in each of the last 3 pre-election years. The S&P 500 actually traded down more than -10% below March’s close in both 2015 and 2011, and in 2007 it traded roughly -3.5% below March’s close in August. In each case the peak-to- trough drawdown was beyond -10% given the drawup that transpired from March’s close over the forward 4 months. Further, I find it a bit head-scratching that we read all about how normal -10% peak-to-trough calendar year drawdowns are during the volatile times, but seemingly pretend they don’t exist during relentless advances. Given the context, a -10% drawdown peak-to-trough at some point over the August through December 2019 time period would be normal and certainly make for interesting (and frustrating) developments. That said, based on what’s transpired since January, I think it would be an awesome pitch to swing at.
Into 2020 - Strength Begets Strength
There’s no denying the S&P 500’s strength thus far in 2019, and it’s set off a frenzy of bullish precedent that would support the idea of much higher prices 1 year from now, even if we stumble a bit in Q3 or Q4 of 2019. My broken crystal ball tells me it’s possible the S&P 500 will trade to new all-time highs by July, experience a -10% correction in Q3 or Q4, and yet still close at fresh new all-time highs in Q1 2020. If you asked me today, that’s my baseline expectation for the forward 1 year.
Here are two of the most interesting studies I stumbled across at the end of March:
Strong Q1 Following Red Calendar Years
Here are all samples where the S&P 500 gained 5% or more during Q1 when following a calendar year that was unchanged or negative. It’s only happened 9 prior times since 1950, but when the S&P 500 slams on the breaks, and flips from reverse to drive, she has absolutely slammed on the gas pedal more often than not (and barely looked back..)
March 6 Month High & 3-Month Winning Streak
The month of March finished at a 6-month high and on a 3-month winning streak. We have 18 prior instances of March ending this way since 1950, and the remainder of the calendar year saw the S&P 500 close higher 17 of 18 instances for median returns of 8.87%. All instances traded up by at least 6.90% from March’s close, which would suggest a drawup to ~3,000 at a minimum at some point over the forward 1 year. Using both median maximum forward 12-month drawdown and drawup to establish a range for the next year would target trading between roughly 2,719-3,209.
So Steve, What Should We Be Doing?
The same thing you should always be doing - investing as if the best is yet to come while being prepared in the event the worst is around the corner. This is executed by having a written Investment Policy Statement (IPS), one that’s built on a sound premise, and adhering to the rules of the IPS with maniacal discipline. Investing for success over the long term isn’t about predicting the price of the S&P 500, and none of what i’ve shared here today has any predictive qualities. Investing for success over the long term is about predicting your own behavior - i.e., when and why you’ll press buy or sell, or rebalance your asset allocation - and then behaving like an adult during the most challenging of times. It really is that simple, no matter how confusing this stuff may seem. If you don’t have an IPS, then you should click the “Invest With Steve” tab.