Stocks typically rally in December, investors have some caution this year

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By David Randall

NEW YORK (Reuters) - Investors hoping for the year-end to bring stock market gains after a punishing year have history on their side as U.S. equities traditionally rally during the month of December, but many remain skeptical of forecasting a rise.

The S&P 500 has gained an average of 1.6% during December, the highest average of any month and more than double the 0.7% gain of all months, according to data from investment research firm CFRA. September, meanwhile, is the worst month of average for stocks, with a 0.7% average decline.

Gains would be welcomed by many investors after seeing the S&P 500 Index fall around 16% so far this year. Still, weighing on the market has been the U.S. Federal Reserve's actions to aggressively tighten interest rates to fight inflation.

"December is usually a good time for investors but right now they are stuck because it’s really the focus on rates that will cause the market to go up or down in the short term," said Sam Stovall, chief investment strategist at CFRA Research.

"The question this year is will the Fed raise by 75 or 50 basis points, and whether there will be any dovish commentary that suggests that the Fed will raise rates one or two more times next year and then call it quits,” Stovall said.

December is typically a good month as fund managers buy stocks that have outperformed over the year for so-called "window dressing" of their portfolios while there are year-end inflows and lower liquidity during holiday-shortened weeks, said Stovall.

At the same time, U.S. stocks have risen during the last five trading days of December and the first two days of January 75% of the time since 1945, according to CFRA, in a so-called Santa Claus Rally. This year, the time period starts on Dec. 27. The average Santa rally has boosted the S&P 500 by 1.3% since 1969, according to the Stock Trader's Almanac.

This year, however, investors' focus has largely shifted to the Fed and the pace at which it will continue raising interest rates as it attempts to bring inflation down from near 40-year highs.

"Investors tend to be optimistic going into the new year but this is still the Fed's market," said Brian Jacobsen, senior investment strategist at Allspring Global Investments. "The old saying is that 'the trend is your friend and don’t fight the Fed,' but now it’s 'the Fed isn't your friend, so don’t fight the trend.'"

Investors are pricing in a 75% chance that the Fed will raise rates at its Dec. 14 meeting by 50 basis points to a target rate of 4.5%, while the probability of another jumbo 75 basis point move is at 24% according to CME's FedWatch tool.

Minutes released Wednesdayfrom the Fed's Nov. 2 meeting showed that a "substantial majority" of policymakers agreed it would "likely soon be appropriate" to slow the pace of interest rate hikes," though Fed members believe that there is "significant uncertainty about the ultimate level" of how how rates need to rise.

Another outsized increase in rates could impede the more than 10% rally in the S&P 500 since the start of October that has been fueled largely by hopes that inflation has peaked from 40-year highs, allowing the Fed to slow and eventually pause its most aggressive rate hiking cycle since the 1970s.

Fed Chair Jerome Powell, who will speak on Nov. 30, has signaled that the central bank could shift to smaller rate hikes next month but has also said rates ultimately may need to go higher than the 4.6% that policymakers thought in September would be needed by next year.

"Sharply reduced valuation for public and private firms is one painful consequence" of higher interest rate costs and will likely mean that the S&P 500 will fall by 9% to 3,600 over the next 3 months, Goldman Sachs (NYSE:GS) strategists wrote in a note Monday.

Still, there may be other reasons to hope for another seasonal rally this year.

Short sellers have covered nearly $30 billion in short positions since the start of the month, with the largest covering coming consumer discretionary, health care, and financial stocks, according to S3 Partners.

"Short sellers are trimming positions as the market rallies, and they incur mark-to-market losses – and possibly trimming positions in anticipation for a year-end rally," said Ihor Dusaniwsky, managing director at S3 Partners.

The painful double-digit declines in both U.S. stocks and bonds, meanwhile, have made both asset classes more attractive for long-term investors, said Liz Ann Sonders, chief investment strategist at Charles Schwab (NYSE:SCHW).

"Things look pretty decent if you have a one-year time horizon, but not without some potentially significant volatility in the next quarter or two," she said.