Mama Said There'd Be Days Like This (The Remix)

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Last week was the first full week of 2025 and with it, we got our first statistical reading for 2025; "The Rule of First Five Days." With the S&P 500 closing above 5881.53 on January 8th, the first positive reading was had. To refresh memories, going back to 1950, if the first five days close positive, and the markets were up over 10% the year before, then there is an 80% probability of a positive outcome, and the average return is 13%. This is not a barn burner like 2023 and 2024, but still, way better than 5% or less in fixed income and the international markets still are in their tailspin. As can be seen below, the S&P has had a less than wonderful start since the election in November. The recent struggles are more apparent when we use a measure of the S&P 500. Using this broad index, we can see that even the large cap stocks have undergone a 7%+ pullback and have returned?to where?they traded before the election.?

What I found most interesting is the symmetry?of this action since the election. Often one of the strange things that happens in the market is that an action often has an equal action in the opposite direction within a continuing trend. As can be seen below, the rise from the election on November 5th to the high point was around 7% and lasted 23 days. From this high point, going to Monday of this week, the pullback from the highs was almost exactly the same with almost the exact same number of days!

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Are Higher Rates Responsible?

It likely isn't a coincidence that the stock market's struggles have coincided with a corresponding rise in longer-term interest rates. The move higher began coincided almost exactly with the Federal Reserve's latest interest rate cut. The spin on this reaction is that perhaps the market believes the lower rates will stimulate future growth, but it also could just mean the market expects inflation to be higher for longer going forward and that rates are not going back down to prior levels anytime soon. This wasn't helped by the fact that Powell made comments to the effect that more rate cuts are in question due to greater economic?strength. The benchmark 10-Year U.S. Treasury yield is now hitting a zone around 4.80% that has previously been important. If it cannot stop the ascent and rates break out, it could start to cause some real problems for equities.

As can be seen above, Treasury yields spiked right around the time of this last rate cut and have now eclipsed the highs from April of last year. The Fed has cut rates by 100 basis points, from 5.50% to 4.50%. Meanwhile, the 10-year has surged, particularly since September to a 6-month high amid expectations of a higher for longer rate environment. This all seemed to be confirmed last week when the non-farm payrolls were up 256,000 when the street expected to rise only 154,000. Not being an outlier, the unemployment rate also dropped from 4.2% to 4.1%. Since the Fed has stated it is data dependent and specifically concerned about labor, these were not good reports as the 10-year yield broke out higher.?

Another, never before seen reason for higher rates is the immense amount of debt on the system.?All the stealth QE due to record levels of interest governments must pay on their debt burdens among other major obligations such as unfunded liabilities such as pensions is pushing inflation higher. Countering this is the material increase in productivity due to AI which can help the US grow its way out of its debt. It might be a technology induced tug-o-war between inflation which will impact interest rate direction thus global liquidity vs. AI-boosted productivity which will boost GDP. Buckle up for possibly more interest rate volatility in 2025.?

Equities Stumble on Rate Rise

?The S&P 500 has come under pressure since the 10-year US Treasury yield moved above 4.5% in mid-December. The trend in interest rates is higher, in my view, but if it goes much above 5% it could such?all the oxygen out of the economic?growth in the economy. While this could create a more moderate pace to the S&P’s advance, this week’s report argues against imminent market-top conditions. Key positives include:?

1) the S&P 500’s intact uptrend. The action of late is merely a digestive move in a longer-term uptrend.

2) high-growth / big-cap outperformance continues to lead vs. low-volatility. Growth is still prevailing over value.

3) credit spreads that show a lack of underlying market stress. If there were, the interest rate on economically sensitive investment grade debt would rise due to fear of cracks in the economy due to too high cost of capital.

For the S&P, the index is correcting from a position of broad-based strength in early-December and is still above its Nov. 6th gap at 5,785. From our viewpoint, this looks like orderly consolidation in an ongoing bull. For us, it’s neither high nor low rates, but stable rates that have historically supported equity market gains. We’d also argue directionally that higher rates have aligned with stronger equity markets as they infer better economic growth. Please refer to the interest rate chart above. The range of interest rates is clear. The issue is really the speed with which the rates spiked back up following the last rate cut.?

With evidence in recent economic data suggesting that inflation could remain stickier for longer, our expectations are for the Fed to continue practicing its dual mandate of nurturing sustainable economic growth without risking a blow back of untoward levels of inflation while maintaining policy favoring “full employment." ?This week will likely find market participants busy pondering the unofficial start of Q4 earnings season when the big US banks begin reporting results today (January 15) along with the release of the consumer price indexes also this morning.

We remain positive on equities. The broad rotation which began in the rally from the S&P 500 low on October 27, 2023, has repeatedly deflected volatility, evidenced on a day to day and week to week basis since the lows in early August. Recent pullbacks have mostly looked like “trims” and “haircuts” for the S&P 500 whenever bears, skeptics, and nervous investors have found a catalyst to take near-term profits without FOMO (fear of missing out) midst what appears to us like a very much intact bull market. With the unemployment rate having dropped a bit more last?week, the Fed Chair has said the Fed is focusing on the full employment mandate part of its dual mandate while remaining cognizant of the need to avoid a blow back in inflation should it begin to cut rates at too fast a pace. The 50bps rate cut rather than a 25bps cut on September 18 in some part appeared to us designed to address the Fed’s mandate and keep the employment factor from softening too much.

Stay Big

I’ve continued to focus on the momentum factor as it has continued to outperform its?smaller and mid-cap brethren?on a comparative?basis. In terms of buying leadership, large-cap growth remains in focus. It is notable that Magnificent-7 is coming off a new cycle high vs. the S&P 500, and subsequent consolidation has upheld the 50-day average. The evidence is compelling: large-cap momentum typically outperforms at this stage of an equity cycle, and large-cap momentum is indeed positioned to outperform, based on our work. Technology deeply embedded in the lives of business and the consumer creating greater efficiencies of execution has contributed significantly to this cycle to the degree of economic resilience stateside that exists to date. We persist in thinking that technology today (including AI) is likely parallel to the automobile in the early 20th century after Henry Ford had mechanized the assembly line and reduced the cost of the automobile while raising the overall quality of vehicles while increasing levels of production resulting in a change in the way business could execute, and consumers could manage their lives. While we favor equities over fixed income, we continue to find fixed income to be complementary to equities and other asset classes within diversified portfolios when duration is matched to investor goals, objectives, and tolerances to risk. We suggest investors look for “babies that get thrown out with the bathwater” when market downdrafts occur in the markets. Ari Wald made reference to this in the "flag pattern" that is being exhibited by the Mag 7 in the chart below. This seems to be confirmed at this point by the action of this group relative to the S&P in the lower part of the chart.

In closing, the market is setting up for a nice risk vs reward opportunity with the continued downside follow through on Friday and into Monday morning, the stock market remains weak and has not yet provided any indication that the selling is done. However, that does mean that the S&P 500 is now getting closer to the 5700-support region (referenced in the S&P chart at the top of this comment) that I have highlighted for what feels like forever now. It isn't there yet and, again, looks primed to still trade lower, though I do think we need to at least be prepared for what could be a potential high quality buy point soon. The best comparison I can make is to the late October/early November period of 2023 then I "backed up the truck" for what I thought could be the start of a larger upside move (although I don't think we should count on the same amount of upside in this case). I do want to give this possible setup room to form.?

As I mentioned last Wednesday, the minimum downside projection from the "Head and Shoulders" pattern in the SPX is around 5550, so there is the potential for a move down beyond 5700 without altering the overall setup. Nevertheless, I think as the SPX nears 5700, one could risk 150-200 points for a possible reward of at least 400+ in the event the S&P goes on to make another new high. Obviously, the market does not exist solely for my benefit and the setup outlined above is not guaranteed to occur or develop in ideal fashion. We must be prepared to adapt in the event that a possible low is struck prior to entering the 5700 region or if this general support zone is not sufficient to boost stocks back up. Given how oversold the market already is, it would not be a good sign for the bigger picture if stocks cannot find buyers near current levels or if the yield on the 10-year continues to rise unrelentingly. The overall risk would go up in that case. So, I think how the market reacts over the next couple of weeks could end up being extremely important. If a low is going to form, it appears to me that it likely does so somewhere around 5550-5700, so we need to be on heightened alert for bottoming signs.

Given that the market has been in a decline since mid-December, it seems that the most comfortable time for scared money to redeploy could be after the Martin Luther King 3-day weekend, which coincides with the Inauguration and the college football national championship. Remember, nothing is a coincidence until it is. The economy is strong, the labor market is healthy, and if Q4 earnings continue to report to the upside, this could be another buying opportunity.

?Ken South, Newport Beach Financial Advisors

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