The December rally may be reaching its climax, with just two weeks to go before Santa Claus makes his midnight run. Dwindling volume, excess optimism, and history all point to a stock market that could be running out of steam.
Investors appear to have grown complacent as the CBOE Volatility Index, or VIX .VIX, has fallen to levels not seen since April. Stocks have made new highs on almost a daily basis. The S&P 500 .SPX closed on Friday at its highest level since September 2008 and the Nasdaq .IXIC scored its best finish since late December 2007, with many expecting gains to run through the end of the year.
But Cleveland Rueckert, an analyst at Birinyi Associates in Stamford, Connecticut, believes the year-end rally may be largely done.
"The majority of that gain may already have occurred," he said. "Most people are more likely to be closing out their books at the end of the month and looking for opportunities to open new positions at the start of the next month."
Rueckert said that over the last 65 years, when the S&P 500 has rallied at year's end, the average gain has been 3.4 percent between Thanksgiving and New Year's. So far, the index has risen 3.5 percent since the start of the period.
"A lot of stocks this year have had very big gains and it really wouldn't be surprising to see a lot of the managers close out positions and take some vacation time," he said.
When trading resumes on Monday, that will start the last five-day trading week before Christmas. The following week will be cut short by the holiday. With December 25th falling on Saturday this year, the U.S. stock market will be closed on Friday, December 24th, in observance of the Christmas holiday.
Inflation data for November will dominate next week's economic calendar, with the U.S. Producer Price Index due on Tuesday and the U.S. Consumer Price Index set for Wednesday.
BULLS IN THE EGGNOG
Some see signs of the bulls getting into the eggnog.
The American Association of Individual Investors' latest sentiment survey shows bullish sentiment reached a four-week high. What's more, bullish sentiment has spent 14 weeks above its historical average -- its longest streak in six years.
That is often seen as a contrarian indicator.
This week, the S&P 500 has broken through closely watched resistance levels and has climbed for six of the last eight days to close at fresh two-year highs.
But gains have been accompanied by decreasing participation. Average volume during the last three days of the week was 7.76 billion, well below this year's daily average of 8.62 billion.
"We are entering now the beginning of the seasonal pattern where volume really dries up," said Nicholas Colas, chief market strategist at the ConvergEx Group in New York. "It seems like it's starting a little sooner than usual.
"I don't think we're at any risk of a meaningful sell-off into the end of the year, but I think the basic contours of what the economy looks like are pretty well set," he said.
That sentiment was reflected in the VIX, also known as Wall Street's favorite barometer of investor fear. Although the VIX edged up on Friday, the index has fallen for six of the last nine sessions. It now stands at 17.61 after hitting its lowest since April.
The 15-day moving average of the advance/decline ratio on the New York Stock Exchange, a measure of the proportion of advancing to falling stocks, has started to slip and currently stands at around 1.5. It peaked this year in July at about double that, according to Reuters data.
In addition, the 3-day moving average of stocks making new 52-week highs has also turned lower after a spurt at the start of the month. It now stands at around 125, down from more than 250 at the start of the month.
The breadth and ratios have not been "on board" this rally of late, according to a report from McMillan Analysis Corp. Equity-only put-call ratios remain on "sell" signals, the analysts say.
Chart-minded investors are bullish. The S&P 500 has closed well above 1,228, the 61.8 percent Fibonacci retracement of the 2007-2009 bear market slide, a key technical level.
"When a market surpasses a certain retracement level, then the probability increases of a rise to the next retracement level, which in this case would be a 76.4 percent retracement and that's a ways up at 1,362," said Chris Burba, short-term market technician at Standard & Poor's.
The 1,120 level, the top of a recent trading range, is seen as strong support.
On Friday, the S&P 500 closed at 1,240.40 and was up 1.3 percent for the week. The Dow Jones industrial average .DJI ended Friday's session at 11,410.32 and was up just 0.2 percent for the week. The Nasdaq closed on Friday at 2,637.54; for the week, the Nasdaq was up 1.8 percent.
LOOK OUT FOR FED HAWKS
An agreement to extend the Bush-era tax cuts over the next two years has started to seem like less of a done deal. The agreement is expected to be approved by the U.S. Senate on Tuesday, but could face a tougher road to passage in the House.
If the legislation stalls, resulting in higher capital gains and dividend taxes at the start of next year, then U.S. stock prices could fall.
The Federal Reserve's policy-making body, the Federal Open Markets Committee, will convene on Tuesday for its last meeting of the year. The recent clutch of stronger economic data could spark a debate over how far to stretch the central bank's $600 billion stimulus plan, designed to keep interest rate low through bond purchases.
"The hawkish members on the Fed may seize on this cluster of strong numbers and use them to support the argument against" quantitative easing, said Pierre Ellis, senior global economist at Decision Economics in New York.
I used to analyze all these technical indicators to death. No more. I don't care how low the VIX is, it could go lower and stay there for a long time. I believe that institutional and retail investors should continue buying any dip that comes their way. Look at November. Everybody thought Europe was going to collapse. Admittedly, the Irish bailout is not a done deal, and Europe is a mess, but the fact remains that there are powerful interests that want to see this rally continue as long as possible.
Why do I believe that QE 2.0 is not the end of it? Two reasons. First, policy remains reflate and inflate at all cost. The Fed and other central bankers will accommodate the global financial system, providing banks with cheap funds to buy bonds, making an instant profit which they use to buy higher-yielding risks assets all around the world. This will shore up bank balance sheets and hopefully trickle to retail investors who desperately need a wealth effect (but wealth effect from stocks is much weaker than the one from real estate).
The second and more important reason why I believe QE is here to stay is that the US economy is still at risk for experiencing debt deflation. I want all of my readers to carefully read Part 3 of an interview posted on Huffington Post between Michael Hudson the report, and Michael Hudson the economist. Part 3 is available here (and you can read Part 1 of "My Talk With Michael Hudson" here and Part 2 here.)
I quote Michael Hudson, economist:
The constraint on this Ponzi scheme was the ability of income to carry the rising debt. As long as interest rates were falling, a given rental revenue or equivalent homeowners' value could carry a rising debt. But once interest rates reached their minimum, by 2006, there was no more leeway left. Homeowners had to pay debts out of their take-home wages, which have not risen in real terms for over thirty years now. The debt charade no longer could be concealed.
This leaves us with the problem of where we go from here. The Obama Administration's "solution" is for the economy to "borrow its way out of debt." The Fed is flooding the economy with credit to get the banks lending again - in the hope that new mortgage lending will restore high prices (that is, high housing costs to new buyers), saving the banks' balance sheets.
But with much of US real estate already in negative equity, banks are not going to start lending again on a large scale. The government doesn't want to confront the fact that we have entered a period of debt deflation. When debtors pay their creditors, they have less to spend on goods and services. So market demand shrinks, corporate profits fall, investment declines and unemployment rises.
To mainstream economists, this is an anomaly. This shows the extent to which creditor-friendly views have swamped common sense in academic economics as well as in Congress. It reflects the power of financial lobbyists to persuade many policymakers to embrace illusion over reality.
I don't agree with Michael that we've entered debt deflation (at least not yet), and corporate profits are rising, not falling. And while I do agree with him on creditor-friendly views swamping common sense in academic economics, I also know that the financial oligarchs and their powerful lobbies have a stranglehold on the economy. They get first dibs, and if there are any crumbs left over, then they'll lend to small and medium sized enterprises (SMEs). The big banks don't care about lending to SMEs. They care about profits, which is why they continue trading aggressively in their capital markets operations. It's liquid and pretty easy for them to lock in spreads and trade high-yielding risk assets.
What does this have to do with the Santa Claus rally? In the short-run, nobody knows how stocks will react. Over on Zero Hedge, RobotTrader posted a link to Investor's Business Daily Top 100 list. Should you rush out to buy Priceline (PCLN) at $400+? It could go higher but the time to have bought PCLN and a bunch of other gems was back in January/ February 2009 when I wrote about post-deleveraging blues and recommended a few of them.
The great thing about the stock market is there is always an opportunity, especially when you have a tsunami of liquidity out there looking for yield. Don't get too caught up in all these technical indicators or in the negative macro news environment. At the end of the day, the powers that be will keep buying the dips because it's all part of the master plan to avoid debt deflation at any cost.
Will it work? That remains to be seen. If you read Hoisington's interim quarterly update, the US economy is still in a growth recession and monetary policy is ineffective. I quote the following:
Commodity loans can be financed at 1% or less. This encourages speculative buying of commodities for inventory, thereby causing food and fuel price increases. For household's of average means, funds for discretionary purchases are quickly drained. This is especially evident since the pump price is now at or above $3 a gallon. A 30-year mortgage rate approaching 5% only serves to accelerate the downward pressure on home prices - the main source of household wealth. In short, higher stock and commodity prices are not a net gain in current circumstances.
So when we speak of Santa Claus rally, we should qualify it. It's great for the financial elite making millions in bonuses, but for the average household struggling to get by, it means absolutely nothing, especially if the economy keeps hemorrhaging jobs or creates insufficient job gains. We are not out of the woods, especially on the economy, but something tells me the stock market will continue climbing the wall of worry, much like it did back in 2004.