By: Steve Sosnick Chief Strategist at Interactive Brokers

In light of President Biden’s State of the Union Address on Tuesday evening, I would like to take this opportunity to offer my own State of the Markets Address. Please save your heckling until the end.

The buoyant market that we’ve seen so far in 2023 is a testament to the persistence of investor optimism and the power of momentum. The idea that global markets would be up by double-digit percentages in the first six weeks of the year amidst a regime of central bank hiking and quantitative tightening, seems mind-boggling. Yet here we are.

The calendar gets a big assist for the eye-catching year-to-date performance. December was a truly atrocious month, particularly for US tech stocks. When we look at some key global indices on a normalized basis to December 1^st, we see that the performance is far less impressive. A good portion of the current rally was catch-up from a terrible year-end. 

Key Global Markets, Performance Normalized to December 1, 2022
S&P 500 (SPX, white), Nasdaq 100 (NDX, dark blue), Euro Stoxx 50 (SX5E, red), FTSE 100 (UKX, purple), Nikkei 225 (NKY, yellow), Hang Seng (HSI, light blue)

(Click on image to enlarge)

Source: Bloomberg

Hong Kong is the clear outlier, benefitting from China’s reopening story. It is a positive for global economies, though some appear to be overlooking the potential for commodity inflation that could result.

But in general, I believe that most of the move that we saw last month was the January effect on steroids. We had huge stocks – including “megacaps” – giving back half or 2/3 of their value during 2022. Think of AMZN, META, TSLA, for example. There were lots of tax-losses to be taken before the calendar turned Just as the current buying has been abetted by momentum chasers, so was December’s selling. It’s no coincidence that some of last year’s — and particularly December’s –biggest losers are some of 2023’s best performers.

To some degree, the same could be said for the dollar, even though its peak occurred in November. Currencies can be momentum driven just like stocks, which makes them prone to overshoot, just like stocks. That said, Europe was spared a worst-case energy crisis. We blame weather for all sorts of earnings woes, we might as well give it an assist when it helps. Whether or not this freakishly warm winter bodes poorly for future generations, but for now it allowed Europe to escape an inflationary spike. That explains a large portion of the solid performance of the euro and pound versus the dollar and the relative outperformance of European shares versus the US. 

Going forward, US equity markets need to resolve a few key elements before we can label this move a stable advance, let alone a new bull market:       

1. Are we continuing to fight the Fed, and for how long? Bond traders, particularly those at the short end of the curve, took immediate notice to the idea that the hoped=-or reduction in peak rates is less likely now than it was a week ago. They also began to price in a smaller probability for rate cuts in the 2^nd half of the year. Bonds and the dollar reversed the moves that they made in the day and a half between Powell’s post-FOMC press conference and the payrolls report. Stocks didn’t. Between rates and quantitative tightening, it is quite clear that the monetary tide continues to recede. It is odd that stock markets seem to be ignoring that fact.
2. Are we going to get the hoped-for soft landing? That seems to be the base case for equity markets, yet true “soft landings” are a historical anomaly. Could the Fed engineer one? Sure. Should that be investors’ base case. Not so sure.   
3. Under what circumstances might we get the rate cuts that are being priced into Fed Funds futures? There is virtually no historical precedent for the Fed to finish an aggressive rate hike cycle, then turn around within 3-6 months to cut rates. It seems illogical that they would declare victory over inflation and then immediately reverse course. This idea has been echoed numerous times by Fed talking heads. The only plausible reason for such a reversal would be if a recession forced the central bank’s hand. We should be careful what we wish for.
4. How has the plethora of short-term options affected the recent market action? Late last year, we saw exchanges list so-called “zero-dated” or “0DTE” options listed in a range of key indices and ETFs.They have proven immensely popular, with cumulative options volume setting a record last Thursday (the day after the FOMC meeting). For better or worse, they have made speculation incredibly easy. It is likely that these products exacerbated December’s decline, and it is almost certain that they have accelerated this year’s rally. Most traders are more comfortable trading from the long side rather than the short side, which explains the recent pops in volume on up days. Over time, the effect will fade. Markets learn to adapt to new financial innovations and speculators can be fickle. But in the short-term, it would not be surprising if these ultra-short-term options lead to microbursts of volatility and the occasional spurious move.

Thank you for your indulgence and patience. We know that many ideas that are mentioned in a President’s State of the Union Address rarely come to fruition. I’d like to believe that markets will be forced to resolve most of the questions we raised here.

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