Oh, by gosh, by golly, it's time for the Santa rally.President Donald Trump signed the Republican tax cut bill Friday morning before leaving for his Christmas break in Florida.
According to "Stock Trader's Almanac," the Santa rally officially begins Friday, the start of the final five trading days of 2017, and ends at the close Jan. 3, the end of the second trading day of the new year.
Some strategists are saying humbug to the seasonal rally because the S&P 500 has already gained 20 percent this year, with 5 percent in just the last five weeks. But Jeffrey Hirsch, editor-in-chief of the almanac, says they've got it all wrong. It's an indicator, not a seasonal trade.
He says the phrase used to explain the year-end phenomena has proven to be true: "If Santa Claus should fail to call, bears will come to Broad and Wall." Hirsch notes that since 1950, the S&P 500 has averaged a consistent 1.3 percent gain in that seven-day period.
"It's an indicator of market health, and if we get the Santa rally, that's good, and if not … The last six times that Santa didn't show up, three were followed by flat years: 1994, 2005 and 2015. Two were nasty bear markets in 2000 and 2008, and a mild bear … in January 2016," said Hirsch.
In 2016, the S&P 500 lost 2 percent during the Santa rally period and continued falling, losing 10.5 percent for the year to date before bottoming on Feb. 11. It then turned around and ended 2016 up 9 percent.
"For the Santa rally itself, a lot of it has to do with the end of tax loss selling and the fact that a lot of us are not around to really trade the market during this period," he said. "It's a period of time where a lot of participants are away, and the smart money comes in and picks up values. It's a time of year for positive vibrations and bullish buying, and if it doesn't happen you get the first sign that things are not so rosy."
Hirsch said while he finds it an important indicator, it's more important when combined with other indicators, such as how stocks trade in the first couple of days in January and the January effect — which is using the first month of the year as a barometer for the rest. "So goes January, so goes the year," is the old adage.
Some find talk of the indicator as just another old Wall Street tradition, kind of like when the traders sing "Wait Till the Sun Shines, Nellie" on the New York Stock Exchange floor on Christmas Eve.
One of those traders, Wall Street veteran Art Cashin, tells me he believes in the Santa rally "a little bit." This past year's Santa rally ended with a 0.3 percent gain, and the month of January was up 1.8 percent.
He said stocks were lifted Thursday, in part by traders picking winners from the sweeping GOP tax bill, approved by Congress on Wednesday. That type of buying could fuel the Santa rally, he said.
Sectors that would benefit from tax reform were trading higher, such as financials, energy, telecom, industrials and materials. Technology companies were trading lower. Many already have a low tax rate and could face new taxes on their overseas operations.
"You could see by the volume, it's not a runaway rally," he said. "Let's remember this year has not been a good year for seasonal patterns. The January effect may be complicated by the tax bill. People weren't doing their tax selling because they weren't sure how things were breaking down."
The market reacted with a mild, not a huge selloff. It's typical of traders selling the news and booking profits before heading off for their Christmas break to relax.
Not surprisingly, as Congress moved the tax bill forward, investors pulled the highest amount out of equities funds in more than three years, suggesting some investors may see "tax cuts" as already priced in.
I don't expect a lot of trading going on next week as most people are off and typically what happens is you get a continuation of the trend that has happened all year. In all likelihood, the market could end the year about where it is now after 2017's very big gains.
What will be interesting to see is if there's any tax-loss selling which didn't take place this year as investors waited for the new tax bill to be passed and whether it will happen early next year, adding pressure on stocks in January.
Of course, I'm speculating, nobody knows what will happen in January and the rest of the new year but now that the tax cut bill is behind us, investors will focus their attention on other things, like the Fed, risks in China, Europe and elsewhere.
While I worry the rally might be nearing an end, others think stocks are the most overbought in 22 years, and history says that's bullish:
It's proved to be a major market theme this year: Stocks are hitting all-time high after all-time high in what appears to be an unstoppable juggernaut of an equity rally. Many say that's cause for concern, as the broader market has seen so few pullbacks this year amid virtually no volatility.I don't know about Jerome Powell's tenure as Fed chair but one thing is for sure, he's not going to be walking into a picnic. All risk assets across public and private markets are extremely overvalued right now.
According to one analysis, however, the market's historically overbought condition is no reason to press the sell button.
The S&P 500 is the most overbought in 22 years, as measured by its 14-week relative strength index, said Ryan Detrick, senior market strategist with LPL Financial. The classic overbought/oversold indicator is historically elevated, above 80.
But Detrick found that when the S&P 500 has become this overbought (in 13 times since 1950), the market has risen the following year all but once, seeing an average annual move higher of 11 percent.
"In other words, really strong returns going forward, even after we are so overbought, which is one of those rare times that maybe this could be a continuation of the bull market. Things still look pretty good, even though we are still historically overbought here," Detrick said Wednesday in an interview with CNBC's "Trading Nation."
This is just another stunning statistic to pile into a record year for records. This year has also produced the longest daily streak ever without a 3 percent pullback, and the most all-time high records for the Dow Jones industrial average.
Though Detrick is bullish at these levels, he said one risk he sees going forward is potential market turbulence as Jerome Powell's tenure as Fed chair begins early next year. "Overvaluations" are also a concern, Detrick said, but corporate earnings continue to be quite strong.
Still, buying begets buying, and that fella is right, an overbought market tends to become more overbought.
To understand why, there are billions of dollars in quantitative hedge funds and commodity-trading advisors (CTAs) chasing trends in stocks, bonds, currencies, and commodities using "sophisticated" mathematical algorithms. Since most markets aren't trending much, stocks have garnered all the attention.
A naive way of thinking about it is using some simple rule like as long as the S&P 500 (SPY) is trading above its 200-week moving average, you guessed it, "JUST BUY MOAR STAWKS!" on any dip:
Of course, I'm being facetious, quant funds and CTAs use very "sophisticated" models to form their price signals but trust me, I'm not too far off. The best CTAs follow some trend following rule and they don't trade often (read Michael Covel's book, Trend Following).
Trend following works until it doesn't, and when markets shift abruptly, watch out, the drawdowns can be just as spectacular as the big gains from following some simple trend following rules.
But traders love breakouts, especially on longer-term weekly and monthly charts, because while everyone expects mean reversion, markets tend to keep melting up, catching everyone off-guard.
It's particularly hard trading when markets enter a melt-up phase, where everything explodes up, and this in spite of the Fed raising rates.
In my experience, this is when the biggest gains are made. This is why I've been trading stocks over the last month like crazy, because I knew as long as that tax bill wasn't signed, markets will keep going higher in anticipation of the new tax plan.
Now that we got this tax bill out of the way, it will be interesting to see if markets keep forging ahead despite the Fed rate hikes.
Personally, I'd love to see a healthy pullback on the S&P 500 (SPY) right back to its 50-week moving everage before it takes off again. It doesn't mean it's going to happen, especially in these markets where traders chase momentum.
But these markets aren't just about momentum and chasing trends. Some argue the fundamentals warrant more upside in stocks.
In fact, Chen Zhao, Chief Strategist at Alpine Macro, sent me this in an email Friday morning:
Alpine Macro’s 2018 Outlook, titled “Unanticipated Boom and Coming Clashes”, is currently being completed and will be released on January 5th . The report’s release will be followed by a live Webcast where I will answer your questions. Here is a preview of the report:Chen is right, don't discount the low-inflation melt-up in global equities in 2018, it might happen and take everyone by surprise.
Entering 2018, the investment community has comfortably converged to the view that economic growth in the U.S. will be around 2.5%, growth in the Eurozone will decelerate to about 2% and China’s economic growth will soften to 6.3%, ergo the consensus calls for a replay of 2017 in 2018. As for markets, most investors are cautious on stocks, bearish on bonds and uncertain about commodities and emerging markets.
Maybe the consensus is right, but we disagree. We are looking for a low-inflation economic boom, driven by private capex, re-leveraging and an possible “race to the bottom” in tax cuts around the world. We are looking for much stronger growth in G7 in 2018, while China’s economy could also deliver a positive surprise.
As for financial markets, our research suggests that the bull market in U.S. stocks has not yet matured. Despite the recent price gains, the total return index for the S&P 500 has not even returned to its long-term trend (see chart above). Should a low inflation boom indeed develop, a “melt-up” in global equity prices could be the big surprise in 2018. We are not particularly bearish on US treasury bonds, but the dollar story will become complicated in the New Year.
Finally, various risks will also escalate next year, suggesting that financial market volatility will be sharply higher. Investors should think about hedging strategy, especially now with VIX index at extremely low levels.
Importantly, after years of quantitative easing (QE), there is still a tremendous amount of liquidity in the global financial system driving stocks and other risk assets higher. And all this talk of rate hikes and reducing central banks' balance sheets is much ado about nothing.
Where I disagree with Chen and the folks at Alpine Global is on their "particularly bearish" call on US Treasuries (TLT) as we head into 2018. Why do I disagree with this call? Simply put, deflation remains the biggest threat as lofty stock markets head into the new year.
This is why I'm still recommending buying the dips on US long bonds (TLT) and still believe that melt-up or meltdown, Treasurys offer the best risk-adjusted returns going forward:
I realize this is counterintuitive but think about this way, if stocks keep melting up, downside risks will soar too, and if they melt down, well, there won't be many places to hide except for US long bonds, the ultimate diversifier in these insane markets.
That's all from me, I wish you Happy Holidays and a Merry Christmas. I will be back next week with some more market thoughts and round up the year.
Below, the S&P 500 is the most overbought in 22 years, as measured by its 14-week relative strength index, said Ryan Detrick, senior market strategist with LPL Financial. He thinks this is "bullish"and he might be right, the Santa rally could persist into the new year.
But I warn all of you, if stocks melt up and you see a parade of bulls on CNBC telling you to "JUST BUY MOAR STAWKS!", keep in mind nothing goes up forever and downside risks are rising if this happens. Enjoy your holidays and if I have time, will beef up this comment over the weekend.