Streetwise for Sunday, December 20, 2020

It is a most wonderful time of the year, at least as far as the stock market is concerned. As of mid-December, the S&P 500 index is up a total of 15.39%, comprised of capital appreciation of 13.39% and a 2% dividend yield. So, is it too much to be asking for a Santa Claus rally this year?

If you are not familiar with the term "Santa Claus rally," it refers to a rise in stock prices during the last couple of weeks of December and the first two weeks of January.

The rally is generally attributed to an injection of additional funds into the market, and to additional trades which must, for accounting and tax reasons, be completed by the end of the year and the funds put to work at the start of the New Year.

Another reason for the rally is the usual fund managers quarterly "window dressing," of their holdings. The Santa Claus rally, also known as the "December Effect," was first recorded by Yale Hirsch in his Stock Trader’s Almanac in 1972.

As a result, the ongoing bull market is likely to result in a reawakening of the animal spirits within both institutional and individual investors. To that end, ask yourself where you think the markets will be a year from now.

Looking at various forecasts, as illustrated by Bloomberg, it is likely that the equity markets will continue their upward trend well into the New Year. However, the pace of increase will be a more modest one that we saw in 2020, with plenty to potentially slow the ascent.

Many are again questioning whether equities have become disconnected to reality as the Covid-19 pandemic rages anew. Lost in the debate is the potential for an explosive economy in 2021 given the magnitude of excess savings that households have accumulated, a sum that Bloomberg estimates probably totals about $1.4 trillion.

Even the Federal Reserve is starting to realize just how beneficial this pot of money will be to the economy going forward. At the November Federal Open Market Committee meeting, Fed staff no longer assumed that another round of fiscal stimulus is coming. The lack of such support was offset in their forecast by household saving. From the minutes of the meeting:

Although this lack of additional fiscal support was expected to cause significant hardships for many households, the staff now assessed that the savings cushion accumulated by other households would be enough to allow total consumption to be largely maintained through year-end.

With Covid-19 vaccinations about to commence, the economy will likely rebound quickly without the need for households to tap accumulated savings. (The median estimate of economists surveyed by Bloomberg is for the economy to expand 3.8% in 2021 after contracting 3.6% this year.)

The primary factor restraining the economy is the services sector, as spending on goods is above the pre-pandemic trend. A vaccine will allow this sector to come online quickly and close the output gap, or the distance between where the economy is and where it would have been in the absence of the pandemic.

Bloomberg estimates of the output gap indicate the economy should be producing 5% more goods and services than were produced in the third quarter.

So, a key question is whether households will tap their accumulated savings, pushing the savings rate below zero after the economy has largely normalized. Bloomberg estimates households have accumulated $1.4 trillion of excess savings, which is equivalent to about 6.6% of gross domestic product.

Policy makers and market participants have yet to fully appreciate the magnitude of accumulated savings because the numbers are so large and out of historical context that they are difficult to comprehend. Also, there seems to be a false impression that savings are already being drawn down. That is just not happening on an aggregate level.

The thing to know is that these accumulated savings represent a massive amount of stimulus that is more than the current output gap and could spark an economy already set to normalize.

Therefore, it is not hard to extrapolate that households will start spending their accumulated savings next year as confidence rebounds and after the economy is already on its way to full recovery. It does not take much imagination to see how that could supercharge an already vaccine-induced hot economy.

Lauren Rudd is a Financial Advisor with Raymond James & Associates, Inc., member New York Stock Exchange/SIPC, located at 1950 Ringling Blvd #401 Sarasota, FL 34236. You can contact him at 941-706- 3449. This market commentary is provided for information purposes only and does not constitute a recommendation. Opinions are those of the author and not necessarily those of Raymond James. Information has been obtained from sources considered to be reliable, but Raymond James does not guarantee the material is accurate or complete. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past Performance does not guarantee future results. One cannot invest directly in an index.