Following Fed Chair Jerome Powell's drastic U-turn in September, the S&P 500 is up 13% since lows reached during the repurchase agreement -- or repo -- crisis and has not looked back since, taking most broader indexes with it higher.
Only the brave few started early and bought the dip as they realized the Fed was hellbent on stoking inflation higher, no matter what the cost. This caused a massive spike higher in U.S. bond yields, a rally in economically sensitive sectors such as energy and mining (commodities) and banking -- sectors that were massively underweight by investors coming into last year's fourth quarter.
Value sectors recovered and were well-bid into the end of the year, along with the market's usual suspects. Technology took the broader index even higher into the new year, with liquidity additions picking up for the repo market, even through year's end.
So far, the Fed's free liquidity taps are still on together with its purchase of Treasury bills, scheduled to remain in place until April. If that turns out to be the case, the market looks well supported, to the detriment of most bears who have ultimately given up and now believe in this liquidity argument. But now what?
Last year's fourth quarter earnings for the markets start in earnest this week, with JPMorgan Chase (JPM) , Bank of America (BAC) , and Citigroup (C) among the first to report. According to Factset, sell-side analysts have made larger-than-normal cuts to earnings for the quarter, decreasing by 4.7% from September through December, larger than the five-year average of negative 3.3%. An estimated year-over-year earnings decline of 2% is expected. If that pans out, it would be the fourth straight quarter reporting year-over-year earnings decline since 2015 to 2016. Utilities and financials are expected to show earnings growth of 19% and 7% respectively, whereas energy is expected to show the worst at negative 32%.
What tends to happen going into earnings season is that analysts get overly bearish going into the actual numbers, only to see the results report a lot better than expected causing a move higher in markets. The S&P 500 is trading on a forward price-to-earnings of 18.4-times, and the index has diverged from its earnings trend. This can be seen along a host of macro indicators from the Purchasing Managers' Index (PMI), Institute for Supply Management (ISM) and other benchmarks. In summary, equities are pricing in a global economic recovery. Now the proof will be in the pudding and companies will need to be meet those expectations to justify these valuations.
As we enter reporting season, buybacks -- which have been one of the strongest tailwinds for the market, especially technology sector -- could cause the market to see a bit of consolidation as we are in blackout period. Companies are also pressed by their investors to increase capital expenditures instead of just focusing on buybacks and dividends. There are multiple reasons to be wary of the market at these levels, and they suggest taking profit, or at least being flat, awaiting a better entry point as one may present itself over the next few weeks. This is not a suggestion to be short as the market is not expensive if you believe in an economic rebound.
According to a Deutsche Bank report, discretionary as well as macro-driven funds, algos and cumulative translation adjustments, have all turned extremely bullish and seem to be "all-in" the equity market currently.
Global equity inflows are suggesting a rebound in global PMI, which are yet to be seen. Risk parity funds have been adding to equity exposure as their bond exposure is falling due to falling bond prices, causing them to chase equities even higher, taking their equity allocation to record highs.
Put-call open ratios are trading at all-time highs going back 10 years, suggesting that following expiration this Friday, the funds may be "exposed" and lose their downside protection. If this put protection is not rolled down, it could suggest a pullback over the next few weeks; some much-needed consolidation.
There is no doubt that the Fed's balance sheet expansion at the rate of around $500 billion over past three months has fueled this rally. One can even argue a year that saw the worst earnings decline saw the massive rally in equities compared to 2018; the power of free money boosts asset prices. The Fed had always argued that it would maintain sufficient liquidity into year-end repo cash demand, which has carried over into January. It remains to be seen what the Fed announces at its Federal Open Market Committee meeting at the end of January to gauge how far it has left to go. As of the FOMC's last communique, inflation was not a concern, and would need to be "considerably" higher for it to even consider raising rates.
The next few weeks can be tricky for market as it digests all the earnings news flow together with stretched technical indicators now that everyone is in the "fear of missing out" camp. But if the Fed does not steer away from its message from last September of doing whatever it takes, the market together with commodities, will continue to grind higher as global growth is already showing signs of stabilizing, and inflation is picking up, causing inventories to draw down.