The Viewpoint: The Santa Rally

All clear into Christmas?

The Santa Rally is another one of the seasonal trends which equity investors point to. It reflects the strong seasonal trend in investment returns, where in November and after Thanksgiving in the US, investment returns have been historically strong. This has been labelled ‘The Santa Rally’.

Rules of thumb are just that – sometimes they work and sometimes they don’t. There is often some logic behind them though and this one in particular. By the middle of November nearly all companies have reported their final results for the year, leading to a reduction in any news flow which could be problematic. This year the third quarter results season has been strong in the US. As of early November, 91% of companies in the S&P 500 have reported Q3 results, with 82% beating expectations. This gives a sense of optimism to markets in the final weeks of the year.

Another reason to be optimistic is the re-opening of the US government after a prolonged period of closure due to budget wrangling. During this closure the US treasury general account, where tax receipts are deposited before being spent by the government, has rocketed to a balance of $1tn. Now the US government is re-opening that money and it will find its way into the economy and indirectly to investment markets – providing a boost to activity. Strong corporate earnings and increased cash being pumped into the economy is a good combination. Add into this the potential for further interest rate cuts in December and Santa would appear to be bringing investors many presents!

The key risk and opportunity for markets remains artificial intelligence (AI). There is a high concentration of investment returns and index exposure to a small number of technology names whose future path will be a key determinant of returns to equity investors. AI remains a complex and fast-moving topic whose end point is not yet defined. Whilst I sit in the AI optimist camp, mainly for the benefits it brings all companies rather than a fixation on purely technology ones, it can feel like equity markets a single weak Nvidia update or new China AI development away from a material pull back. On balance though, I think there are more reasons to be optimistic than pessimistic going into the final weeks of the year.

AI remains a complex and fast-moving topic whose end point is not yet defined.

What is risk?

Much of investing focuses on the reward side of the equation. It is very clear what investment returns have been delivered, as this is a simple mathematical equation. What risk was taken to deliver those returns is less quantifiable. There are many ways to measure risk, and different investors use different metrics. Broadly however, those who manage risk fall into two categories.

The first is risk as volatility relative to something, usually a benchmark like the FTSE All-Share or S&P 500. These investors effectively treat the benchmark as ‘risk free’ and the deviation from this as the risk taken. The second category take an absolute approach to risk. This treats risk as the potential for permanent and material loss of capital and is usually managed at the individual investment level. Different investors have different goals, with some being more benchmark (and therefore volatility) focused, and others looking more at absolute return and therefore more concerned about capital loss. Both approaches have validity and of course investors can use both.

The reason I mention this is that at certain times in the cycle the benchmark is more risky and I think that now is one of those times. This makes relative risk management more difficult than absolute. If we look at the MSCI ACWI (all country world index) nine of the top 10 weightings are AI-driven stocks. Adding to this, these nine now make up 25% of the index. This means that the index, which is often used as a benchmark, has become a significant bet on one area, AI. This makes the index, depending on your view on AI, far from risk free. Understanding the level of risk embedded in a benchmark is critical for volatility and relative performance-led investors, as they can be taking far more risk than they realise at certain points in market cycles.

This makes the index, depending on your view on AI, far from risk free.

At this time an absolute approach to risk can be very helpful. Looking at each of these nine companies (Nvidia, Apple, Microsoft, Amazon, Alphabet, Broadcom, Meta, Tesla, Taiwan Semiconductor) they are quite different businesses despite their commonality with AI. Concluding which are good investments and which are not, and which have the potential for permanent capital loss, is an essential part of risk management. Should all these companies do well, the benchmark will do well. But if they prove to be overvalued or AI overhyped, there is significant risk in the MSCI ACWI benchmark. Of course, and as I have noted in previous blogs, it is right to keep an open mind about AI and its influence on markets and companies. As always though, it is important to understand the risks you are taking as an investor.

Was the US exceptional after all?

One of the more memorable beliefs this year was the end of US exceptionalism. As is the case with investing, almost as soon as it became accepted principle, US markets began to perform well again. It did have, and still has, a logic to it as political, legal and economic institutions in the US seem to be degraded – and things we have criticised China for are becoming more prevalent there. It will take many years to know if the damage has been permanent.

It does remain the case, as the CEO of Microsoft pointed out, that the US is 4% of the world's population, 25% of its GDP, and 50% of its market capitalisation. Global investing has become much less global in the last decade as US technology companies have grown to the size they have. This is the reason why there is such interest in the potential renaissance of other economic regions, which have the potential to unleash even larger populations in the quest for economic activity and ultimately investment returns. India, China, Latin America, and even Europe have, at least in theory, the potential to become much more important areas for investment in the future.

The US is 4% of the world's population, 25% of its GDP, and 50% of its market capitalisation.

The US remains unique though. It is an energy independent, relatively stable political, rule of law and capitalism-based society. It remains the main place talented people, who have an idea and want to grow it, often end up in. It is hard, maybe impossible, to have the same results in regions which do not have these characteristics. Whilst I think other economic regions will have times when they outperform the US, perhaps even for some time, the US is indeed exceptional. Another rule of thumb is don’t bet against the US, and this one is more based in fact than the Santa Rally.

For professional investors only. This material is not suitable for a retail audience. Capital at risk. This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.