Wall St Week Ahead: Stocks approach historically strong period but Fed taper looms

Investors are weighing whether momentum from the stock market`s record-breaking rally will continue in the last two months of 2021, a traditionally strong calendar period for equities but a stretch that may carry more risks than usual this year.

The S&P 500 has rallied 22.6% year-to-date, its best January-through-October performance since 2013, and November and December tend to be among the strongest months for stocks.

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This time around, however, the year-end period may have more than its usual share of pitfalls, as investors brace for the looming unwind of a $120 billion-per-month Federal Reserve government bond buying program that has helped stocks more than double from their March 2020 lows. Many are also keeping a wary eye on ructions in the bond market, as well as worries over looming inflation and a debate over tax legislation in Washington.

“If the appropriate items fall into place you could continue the seasonality of a year-end rally," said Alan Lancz, president of investment advisory firm Alan B. Lancz & Associates in Toledo, Ohio.

November traditionally has started a bullish period for U.S. equities. Since 1945, the S&P 500 has climbed an average of 6.8% in the November-through-April period, the highest average change for any rolling six-month span, compared with an average 1.7% gain from May through October, according to Sam Stovall, chief investment strategist at CFRA.

In particular, November and December have been the S&P 500`s second- and third-best months of the year since 1950, with the index rising an average of 1.7% and 1.5%, respectively, according to the Stock Trader`s Almanac. The benchmark index gained 6.9% in October, helped by a better-than-expected start to the earnings season.

One major test for that run will come as the Fed begins to taper its bond buying program, a move the central bank is expected to announce at the end of its monetary policy meeting next week. While officials have telegraphed plans to begin reducing bond buying as early as November, investors will be listening for signals that the recent surge in inflation may force the central bank to taper and eventually raise interest rates faster than expected.

The Fed`s communication about its view on how sustained the recent surge in inflation will be is critical to markets, said Anu Gaggar, global investment strategist at Commonwealth Financial Network.

"So far they have maintained that this is transitory, but if we see a change in the wording around that, that could potentially spook the market a little bit,” Gaggar said.

Investors are tracking volatility in the bond market, which has come as rates for short-term U.S. government bonds soared in response to expectations that surging inflation will force the Fed and other central banks to tighten monetary policy more aggressively. While those recent moves have not weighed on stocks, surges in longer-dated Treasury yields could make equities less attractive for some investors.

In Washington, legislation to increase spending on infrastructure could boost some areas of the market, but investors are also wary of proposals that might create higher levies on corporate profits, income or investments. On Thursday, President Joe Biden was dealt a setback as the House of Representatives abandoned plans for a vote on an infrastructure bill.

Some high-profile investors see the potential for downside. BofA Global Research this week called for a year-end target on the S&P 500 of 4,250, about 7.5% below current levels. BofA analysts pointed to extended valuations, "near-euphoric" sentiment and a bevy of risks to corporate profit margins, including potential tax hikes and labor inflation.

Lancz said that given the "phenomenal" stock gains in October, those returns might be "borrowing a little bit from what we might see in November and December."

Still, market declines have been met with swift buying in 2021. The S&P 500`s biggest drop this year - a 5.2% fall from early September to early October - was recouped in just 13 trading days.

"The market has, at every turn this year, surprised people," said JJ Kinahan, chief market strategist at TD Ameritrade in Chicago. "Every time people leave it for dead, the buy-the-dip mentality has continued to be strong.”