Author: Kent Moors, Ph.D.
These days, everybody seems to be talking about the so-called Santa Claus Rally. I prefer to call it a “bounce,” since it does not have any of the hallmarks of a real rally. Nonetheless, there are reasons why it appears along with indications that it will not survive much into the new year.
When the figures settled on Thursday (the last trading session last week as the markets took Friday off for a Saturday Christmas), the three major indices continued a rebound. The Dow ended up posting a nice 1.95 percent rise for the current rolling week daily average (adding the most recent closing value, deleting the earliest), with similar positive readings recorded by the S&P (2.59 percent) and the Nasdaq (3.47 percent). The Nasdaq has been moving back more strongly because it had experienced a more concerted loss prior to this week.
In last week’s Reviews for Sigma Trader and PRISM Profits members, I commented on what the bounce actually meant and why it tends to occur. As I noted then:
This one is hitting a bit early. Normally, the “rally” emerges over the last five trading sessions of a calendar year, extending into the first two days of the next. In 2021, that means it should have begun today [December 23], continue through next Thursday [December 30] when the trading year again ends a day early (with New Year’s also on a Saturday), and then end at close on January 4. But it has been building since Tuesday.
Analyst Yale Hirsch first identified the “event” in his Stock Trader’s Almanac for 1972. It has occurred 76 percent of the time since then.
There are a number of anecdotal reasons why it tends to occur quite apart from the movement in any underlying market fundamentals. For my purposes, there are the following five. Each of these, in turn, is signaled by anomalous trends of its own.
First, there is a recovery from so-called “tax loss harvesting” taking place earlier in December when portfolio managers sell to balance books prior to the end of the fourth quarter with a rise following before year’s end as markets return to equilibrium. In more recent years, this has also extended into some repurchasing later in December to offset changes in holdings. This may partially explain the earlier than usual pop this year as prices came off of unusually low levels prompted by concern over the omicron COVID variant and overreactive selling earlier in December.
Second, there tends to be a pattern in short selling that adds to the “rally.” In more normal years, those betting against the market tend to be less active as trading approaches Christmas and New Year’s. Once again, this year appeared to be an outlier as short selling was one of the main reasons for the unusual dive in market performance well into December. Other more exotic derivative plays were also reinforcing this pressure over the same period.
Over the past week, however, both shorts and derivative usages applying negative influence on the markets noticeably declined, providing an opening for a trend up.
Third, there are the heavier than usual results in the exchange traded fund/exchange traded note (ETF/ETN) flow rates. This is one of the four signal categories I regularly track each week in these Reviews. But they are also factoring into the rally. ETFs allow investment in a range of stocks by mimicking an underlying index of equities (acting like more traditional mutual funds on steroids). ETNs are investment in paper cut on what an underlying index does.
Over the past two years, portfolio and private wealth managers have been increasingly reliant on ETFs an ETNs to provide a foundation for the holdings they offer to clients. The amount of investment here has been consistently rising with this year’s holdings an all-time record. That means the managers need to find outlets for the expanding funding provided. While this has resulted in some managers no longer accepting new investment (even by existing clients), most others have needed to find places for the money. Almost by default, that has resulted in positive rises in ETF/ETN flow rates (quickly rebounding from movement in the other direction earlier in the month as investors panicked over market declines).
The rise has been especially noticeable over the past truncated week, where the move in has been the strongest of any similar period in the past six months. Another end of year trend favoring the ho-ho-ho rally.
Fourth, ceteris paribus (all other things being equal), the traditional lighter trading volume moving into the holidays tends to favor a rising in prices. This is usually augmented by the fifth main element.
This is the phenomenon known as “the January effect,” referring to the statistical observation that January on average provides a better aggregate return than other months in the year. According to this reasoning, more equity purchases are made at the end of December (during the above mentioned lighter overall volume) to benefit from a rising market early in January.
I would caution against this last factor holding true this time around. The number crunching arising from my Σ Algorithm trading system calculations still point toward January 2022 being the onset of a significant bear market, although those runs conducted over the past two days are providing the first signals that this may happen later in the month.
That it is coming, on the other hand, is still not in doubt.
OK, so what does this mean as we move into 2022? The bounce will taper off quickly, since there are no internal market dynamics to keep it going and trading returns to normal parameters. COVID continues to press expectations for an overall economic recovery and the specter of inflation continues to build.
This latter consideration will take over as we move through January. Interest rates have recently taken a back seat in what has been affecting investments as the stock market rallied. But it will quickly return as the primary harbinger of inflation, especially in light of the Fed telegraphing that it will be ending artificial support for fixed income yields and begin rising interest rates several times next year. Those hikes will probably begin about June.
Our bellwether here – the 10 year note yield – ended last week up a strong 6.49 percent and is now once again bumping up to the 1.5 percent yield rate. That may shortly provide a floor for a rate that should be increasing toward 2 percent throughout the first half of 2022.
As a further observation, a private survey – one having some impact on how insiders view the markets – circulated last week concluded that more than 56 percent of the analysts contacted believe a major market correction is coming, with over 80 percent of those suggesting it will be 10 percent or more.
Once again, the shadow of stagflation is creeping onto the conversation. I have discussed this development before but the prospects seem to be increasing. Stagflation occurs when economic growth rates remain subdued while both unemployment and inflation increase. COVID’s omicron provides the first element, the end of a hiring recovery in response will usher in the second, while a combination of Fed action and a tightening credit market will introduce the third. It is setting the stage for a perfect storm.
So, enjoy the bounce while it lasts. As Bette Davis said in “All About Eve” (in one of the most misquoted movie lines of all time), “”Fasten your seat belts, it’s going to be a bumpy night.”
Dr. Kent Moors
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