Santa has stuffed investor stockings with a 10% rally so far. Better earnings, lower inflation, and continued economic strength have encouraged skeptical investors to reconsider stocks as we sled into 2024. But with yields down substantially and highly positive earnings expectations baked in, what could possibly propel this market higher?
Santa has delivered! The S&P 500 now has advanced 10% of the Halloween lows. Even more encouraging, participation has broadened beyond the lauded Magnificent 7 with small caps, mid-caps and internationals all rallying as well. Beneath this advance lies the combination of better-than-expected 3Q earnings (+4% versus expectations of -1%), better-than-expected inflation readings (.2% versus .3% last month), and signals of continued Q4 economic strength (GDP now 2.2%). Combined, their influence has pushed the 10-year Treasury yield down below 4.5%. Remember, lower yields translate into higher stock multiples. Specifically, a .5% reduction in yields accommodates a multiple increase of 2. This may not sound like a lot, but with the P/E on the S&P 500 near 18, two turns higher translates into a 10% advance for the index, as we have seen. For indices trading at lower P/Es, interest rate drops mean even more mathematically, as we discussed in last week’s email. But for this Santa Claus rally to continue, we either need yields to fall further, earnings expectations to rise further, or investor funds to chase this advance. Having spilled a lot of ink on earnings and interest rates this week, let’s look into investor money flows.
Show Me the Money
High anxiety levels for investors should correspond with low allocation levels to riskier assets. This has certainly been the case as investors have pulled billions from equity mutual funds and ETFs this year. In fact, the degree and duration of outflows at this level were last seen during the pandemic panic, despite the double-digit gains for the S&P 500!
Unsurprisingly, much of that money found its way into bond funds, which have provided mixed results as yields have risen. However, recent data suggest equity investors have become more optimistic:
Over the past week, investors pumped $6.5 billion into equity funds helping to fuel Santa’s sleigh, the largest weekly inflow since June 14th and the third largest of the year. As retail investors have become more generous with their equity allocations, fund managers themselves have become more optimistic. In fact, according to the most recent Bank of America Fund Manager Survey, fund manager confidence in equities has hit its highest level in over a year and a half:
With recent retail and institutional confidence rising for US equities, we should examine how much flow potential resides in US money market funds.
Wowza! Money Market funds recently reached a record high of $5.73 trillion. To put that number into perspective, the US equity market capitalization only totals $46 trillion, meaning that even a slight migration of these funds into US equities could add substantial uplift. But with Money Market Funds yielding north of 5%, why would investors move funds elsewhere? They may not… for now:
As disinflation trends become more credible, Fed rate cuts become more probable. Currently, Fed Funds futures have priced in no further rate increases for 2023 and nearly four rate cuts in 2025. By the end of 2025, the market expects a Fed Funds rate of less than 4%. As prospects for money market fund yields diminish, hurdle rates for equity fund returns diminish as well, making longer-term stock market allocations more attractive as shorter-term interest rates fall. For those wondering what could possibly power this market higher… just follow the flows!
Have a great weekend and a very Happy Thanksgiving!
David S. Waddell
CEO, Chief Investment Strategist