The Federal Reserve deflated what hope remained for a Santa Claus rally and reinforced the view that the market will test or even break its lows in the first half of the new year. The Fed raised interest rates by a half percentage point Wednesday, as expected. But, it also forecast a higher terminal rate — or end point for its rate hikes — of 5.1%. At the same time, it raised its forecast for core inflation next year to 3.5% from 3.1%, and downgraded gross domestic product growth to just a half percent from 1.2% for 2023. Selling in stocks accelerated Thursday, with the Dow Jones Industrial Average down 2.3% at 33,202, and the S & P 500 closing off 2.5% at 3,895. Treasury yields, which move opposite price, declined, with the benchmark 10-year Treasury yield falling to 3.45%. "Every single statistic the Fed changed yesterday was equity market bearish. Period," said Julian Emanuel, head of equity, derivatives and quantitative strategy at Evercore ISI. Emanuel pointed to the Fed's revision in its unemployment forecast from 4.4% in 2023 and 2024 to 4.6% in both years. "The bottom line is ... there's never been a rise in unemployment of that proportion, from the 3.5% low in July, when you didn't have a recession, and you never had a bear market bottom prior to the start of a recession," he said. Todd Sohn, technical analyst at Strategas, said the market's trading Thursday signaled more negative action ahead. "What you had today was the S & P hitting a one-month low, and when you're in a downtrend, the one-month low says 'step aside' on the risk that things could get worse and you could end up retesting that low," he said. Strategists said there were really no big surprises in the Fed's statement, projections or comments. But investors had been hoping a better inflation reading would make the Fed a little more dovish. Markets have also been expecting a pivot in Fed policy ahead of the end of next year, with the futures market pricing in at least one rate cut by the end of 2023. "I think investors were sort of convincing themselves that the Fed was going to drop hints that they will be done raising rates by the end of March, and they will consider cutting rates by the end of 2023," said Sam Stovall, chief market strategist at CFRA. "The first part hasn't changed all that much. Their terminal rate at 5.1% still says a 50 basis point hike in February, 25 in March. That really hasn't changed." Stovall said that, going back to World War II, the Fed has historically cut rates about an average eight-and-a-half months after its last rate increase. "That would put us squarely in December for the first rate cut. I think since the Fed said we're not going to cut rates in 2023, I think that's what the market is reacting to now. I think the market was going to retest the lows anyway, mainly because market bottoms mostly have retests," he said. Is Santa coming? Stovall said the market could see a slight Santa rally at the end of the month, going into the beginning of January. He said the average gain for the traditional rally in the final five sessions of December and the first two trading days of the new year is 1.3%. The S & P 500 reached a low of 3,491 on Oct. 13. The index is down 4.8% for the month so far, and 18.3% for the year. On Wednesday, stocks flip-flopped, rising early in the day, falling after the Fed announcement and then coming off their lows. "The Fed projecting growth of half a percent next year was the closest the Fed could come to projecting a recession," said Emanuel, of Evercore ISI. "The reason they couldn't project a recession is it would not be a message the market could parse at all, given the average [terminal rate forecast] is 5.1% next year ... The combination would be more Volcker than Volcker." Paul Volcker was the last Fed chair to wage a major fight with inflation, and he famously pushed interest rates above 20% in the early 1980s to stop spiraling prices. What to do Emanuel said his current market strategy is to play defense within the stock market, and he expects stocks could stage a slight Santa rally right at the end of the year. Emanuel then expects a retest of the lows some time in the first half. Many Wall Street strategists expect a choppy start to 2023, with a test of the lows, then improvement in the second half. "We were overweight financials. We took that off and substituted it with consumer staples," he said. "In my almost 10 years of doing strategy, I never expected to have a sufficiently defensive posture as to warrant an overweight of consumer staples." Emanuel said he was also overweight health care and energy. He said consumer staples and health care typically outperform when inflation is high and falling. "We show upside to the market next year. The environment of falling inflation will be able to offset slow growth through a recession and really set up the cathartic buying opportunity," he said. Sohn said the defensive consumer staples sector is not as attractive from a yield perspective as it had been. "For the last decade, I would buy consumer staples for defensive posturing or if I needed yield," said Sohn. "Now that yields across the yield curve are higher, I don't necessarily need to get that yield from equities. I could just buy Treasurys." Sohn said there's still a chance for a Santa rally, but he expects it may have already happened. "I'm not ruling it out because there's been some internal improvement. Tech is still weak, so that's going to weigh on the market. Tech is tired. Health care is holding up and health care is okay," said Sohn.
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