A Santa Claus Rally?

A Santa Claus rally in stocks this week cannot be ruled out.  There is little US economic data scheduled for release and stocks may have overreacted to fears of recession in the past two weeks.  

The Claims data offer reason to think the market overreacted.  Initial and Continuing Claims both stopped rising in the past two weeks, providing hope that the economic slowdown is not snowballing.  To be sure, the Claims data (as well as some other evidence) so far support the idea of a slowdown in December Payrolls and an increase in the Unemployment Rate.  But, these prints would be consistent with a slowdown, not a recession.

Besides Claims, the other US economic report of interest this week is the Chicago PM.  It has done a good job predicting the m/m direction of the Mfg ISM since April.  Consensus looks for an increase in Chicago.  Other survey data are mixed, but none has as good a tracking record as Chicago.

If the market pulls back its fear of a near-term recession, perhaps as a result of not-so-bad prints for the December Employment Report and Mfg ISM, a sustained rally will probably depend on Q422 corporate earnings.  Right now, consensus appears to be for a slight uptick on a y/y basis, despite a sequential q/q decline.  The macroeconomic evidence (see table below) shows some negatives -- slower growth here and abroad, as well as a still strong dollar and a slowdown in oil prices.  But, profit margins may still be supportive of earnings, as prices may have climbed faster than wages (on a y/y basis).  Earnings may have to exceed consensus for stocks to climb further.

The extent and duration of a stock market rally, however, would be constrained by the Fed's intent to keep economic growth slow enough to generate slack in the labor market.  The economy would likely respond positively to an easing of financial market conditions (which include higher stocks), contrary to the Fed's desire.  So, additional Fed restraint, by further rate hikes or through tough Fedspeak, would likely serve to undermine the rally.  Until labor market slack is sufficient, e.g., with the Unemployment Rate at or above 4.8% and wage inflation slowing, the potential for an aggressively restrictive Fed will hover over the stock market.  The end result may be a cycling stock market over next year or so, possibly within a broad range.

                                Macroeconomic Evidence Regarding Corporate Earnings

                                                                                                                                           Markit
                                                                                                                                          Eurozone                        Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)

Q421            5.5                  82.4                +1.3                              4.6           5.0               58.2  

 

Q122            3.5                  63.4                +2.7                              5.4           6.4               57.8  

Q222            1.8                  60.9                +5.3                              5.3           6.0               53.9

Q322            1.9                  31.9                +9.0                              5.1           6.3               49.3

Q422            0.9                    6.7                +8.9                              4.5           6.0               47.1                                    

                                                                           

* Based on the Atlanta Fed Model's latest projection of 2.7% (q/q, saar).