There comes a time when every party hits a lull, at which point it either picks up again or disperses in disappointment. The stock market hit that point this past week.
With the S&P 500 index on track for a 20% gain for a second consecutive year, sentiment was always going to be an issue heading into the end of the year. Investors were feeling good about their portfolios, Wall Street was riding high, and everyone was talking about the return of animal spirits.
But when everyone is having a good time, even the expected can catch folks by surprise. That was the case with Wednesday's Federal Reserve announcement. The Fed cut interest rates by a quarter-point, just as the federal-fund futures market suggested it would, while the so-called dot plot showed just two cuts in 2025.
It was the "hawkish rate cut" that commentators had recently been warning about. The S&P 500 dropped 2.94% that day, its worst Fed day since 2001, while the Dow Jones Industrial Average suffered its tenth consecutive loss, its worst losing streak since 1974.
The Sevens Report's Tom Essaye notes that two things in particular caught investors offside. First, the shift to fewer rate cuts in 2025 means that the Fed will be less of a force for good in the market than it was heading into the meeting. The language of the statement also changed in a way that suggested rate cuts could be off the table completely next year. "Bottom line, the Fed provided a legitimate surprise," he writes.
But these factors might not have created the same problems if investors hadn't been so bulled-up in the first place. Essaye points out that with the S&P 500 trading above 6000, stocks were priced for perfection -- the index was trading at 22.7 times 12-month forward earnings before the meeting -- and a slightly more hawkish Fed is certainly not perfect. He also notes that investors widely expected the S&P 500 to build on its 25% gain into the end of the year -- the so-called Santa Claus Rally -- and weren't prepared for the alternative.
The statistics back him up. The American Association of Individual Investors sentiment survey showed the number of bulls dropping heading into the meeting. The BofA Sell Side Indicator, a measure of the average stock position recommendation in a balanced fund, sat at 56.7% at the start of December -- still neutral, but closer to a sell than a buy, according to the firm's strategists. The Cboe Total Put/Call Ratio, a measure of those using options to bet on market upside versus downside, also reflected little bearishness heading into the meeting.
When almost everyone is feeling nonchalant about the risks, that's a good time for the market to remind them. Expect to see those shorter-term sentiment indicators reflect more bearishness in the weeks ahead.
A collapse in near-term sentiment would likely be good news for stocks. Rallies, like bull markets, are born on pessimism, and the more pessimism this past week's selloff produces, the bigger a foundation there will be to build on. Conversely, bull markets die in euphoria, and the recent drop has likely done little to change what has been jubilant investor sentiment over the longer term.
And that's what Citigroup's Levkovich index shows. Once known as the Panic-Euophoria index, its name was changed to honor its creator, Tobias Levkovich, the firm's longtime strategist, who died tragically in 2021. He created the measure as a way to help gauge where the S&P 500 would be in 12 months based on 10 sentiment factors. When the index sits in panic territory, it has typically meant that the stock market would be higher in a year; when it's in euphoria, the market typically is lower in 12 months.
There have been a few changes to the measure since Levkovich's passing, says Scott Chronert, who succeeded Levkovich as Citi's U.S. equity strategist, but the goal is the same. As of Dec. 13, it sat at its highest level since 2021, which suggests that the S&P 500 could fall 7.1% over the next year. But the measure can stay in euphoric territory -- and get even more extended -- as was the case following the pandemic and during the dot-com boom. "Euphoric episodes can persist until there is an event or shock that changes something," Chronert says.
It remains to be seen whether Wednesday's Fed meeting was that shock. Sevens Report's Essaye doesn't think it is. Despite the consternation over the Fed, he believes the bias is still for lower rates, while the economy and earnings should continue to grow, and inflation should continue its slow, downward push toward 2%. "Bottom line, markets will be more volatile in 2025 but the medium- and longer-term uptrend should stay intact," he writes.
