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Last week, we noted that the current rally was exceptionally extended, and corrective or consolidative action was necessary.
"While it seems as if 'nothing will stop the market,' such was the same sentiment we discussed in July in "Trading An Unstoppable Bull Market." To wit: 'We must remember that market advances can only go so far before an eventual correction occurs. My best guess is that if the markets are to reach all-time highs this year, we will likely have a correction to reset some of the more extreme overbought conditions.' Of course, that correction came the next month."
While the market struggled to advance early in the week, on Thursday and Friday, markets climbed to set new closing highs for the year, as shown. However, the combination of overbought conditions and excess bullish sentiment limited gains from weaker-than-expected economic reports that should keep the Federal Reserve at bay next week. It is worth remembering, however, that we are still lower nearly two years later. Most investors have spent the last 15 months making up losses, and markets may struggle next year.
As noted by YahooFinance on Thursday:
"Historically, volatility tends to contract at the end of December, paving the way for predictable year-end gains. But this year, November's gangbuster returns may have brought forward an early Christmas for investors. Stocks have had three principle catalysts over the last two years — inflation, jobs, and the Federal Reserve — and all three are on the docket over the next week. Whether bullish or bearish, markets could get quite interesting in what is normally a sleepy time of year."
The jobs report yesterday was weak across the board, which will likely keep the Federal Reserve on hold for now, and next week is the inflation report and the last FOMC meeting for the year. With volatility at extremely low levels, as shown, a hot CPI report or a "hawkish message" from the Fed could cause stocks to stumble.
The message remains that risk is prevalent at the moment. However, the question is whether the "Santa Claus" rally was pulled forward.
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The Santa Claus Rally Cometh
As we start moving into the last few weeks of the trading year, investors everywhere are hopeful that "Santa Claus" will visit "Broad & Wall."
The actual Wall Street saying is, "If Santa Claus should fail to call, bears may come to Broad & Wall." The Santa Claus Rally, also known as the December effect, is a term for more frequent than average stock market gains as the year winds down. However, as is always the case with data, average returns sometimes differ from reality.
Stock Trader's Almanac explored why end-of-year trading has a directional tendency. The Santa Claus indicator is pretty simple. It looks at market performance over a seven-day trading period – the last five trading days of the current trading year and the first two trading days of the New Year. The stats are compelling.
"The stock market has risen 1.3% on average during the 7 trading days in question since both 1950 and 1969. Over the 7 trading days in question, stock prices have historically risen 76% of the time, which is far more than the average performance over a 7-day period."
The end of the year tends to be strong for a couple of reasons. First, professional managers tend to "window dress" portfolios for year-end reporting purposes. Secondly, given that many professional funds make year-end distributions, there tends to be a need to rebalance portfolios. The following two graphs in orange show aggregate cumulative returns by day count for the December 30th months we analyzed. In the first graph, we plotted returns alongside daily aggregated average returns by day. The second graph illustrates the percentage of positive days versus negative days by day count and returns.
Visually, one notices the "sweet spot" in the two graphs between the 10th and 17th trading days. The 17th trading day, in most cases, falls within a day or two of Christmas.
Did Investors Front Run Santa?
While there is a high probability that stock prices will climb, there is a not-so-insignificant 24% chance they won't. With the substantial November advance, the question is whether anyone is "left to buy?" We want to analyze the technical backdrop to minimize the risk of "getting a lump of coal."
As noted, not every December has a "Santa Claus Rally." 2018, as shown, is a good reminder that once in a while, investors receive a lump of coal in their stockings.
At that time, the Federal Reserve was on a rate hiking campaign and insisted that it was "nowhere near the neutral rate" on monetary policy. Furthermore, since the market had declined steeply since early September, sentiment and investor positioning were very negative.
However, this year, such was not the case as the S&P 500 rallied nearly 9% for the month. Notably, this rally followed a 10% decline from August to October, which sent investor sentiment to bearish levels. As shown, the resurgence in bullish sentiment is quite astonishing.
The difference today is that while the Fed has not cut rates, they have signaled they are close to, or at, the end of its rate hiking campaign. This gave the bulls an early "Santa Claus" gift that "rate cuts will soon be here." With such a surge in the market, the question is whether bullish investors front-ran the year-end rally.
Buyers Fading
From a technical perspective, the biggest concern is the more extreme exuberance the markets have seen recently. You have to wonder precisely how much "gas is left in the tank" when the bears are bullish.
While such extreme bullish sentiment isn't necessarily bearish, it does suggest that further upside in the markets is likely limited until a reversal occurs. Furthermore, such a consolidation or correction should be anticipated. As shown in the table below, in previous years, when November was "hot," December was not.
Given that the market is currently overbought on a relative strength basis and well deviated above its 50-DMA, a correction to resolve those conditions remains probable.
Such becomes more likely as inflows into equity funds continue to wane as we head into year-end.
Notably, one of the significant drivers of the gains in November was a surge in corporate "stock buybacks." We addressed such mid-September in "October Weakness Before The Year-End Run." To wit:
"Lastly, corporate share buyback windows will reopen in November and December as companies exit their earnings 'blackout period.' Notably, the last two months of the year represent the best two-month period of the year for corporate executions. Such is because corporations have a clear picture of their current financial positions and can use stored cash to execute buybacks. As noted by Goldman Sachs, 'The VWAP machines will be lining up to buy $5bn worth of equities daily during November and December.'"
The buyback bonanza did not disappoint, as shown in the chart below.
However, that window closed on Friday, eliminating a key "buyer" of equities from the market through year-end.
With the markets overbought, bullishness elevated, and stock buybacks over, a reversal into the last week of December remains possible. Of course, the good news is that such a correction would set the stage for "Santa Claus to visit Broad and Wall," after all.
Calculating The Madness
Let me repeat something that seems apropos currently:
Sir Isaac Newton once said:
“I can calculate the motions of the heavenly bodies, but not the madness of the people..”
As we head into year-end, we will navigate the risk of overly extended and bullish markets against the seasonally strong end-of-year period.
We believe that capital preservation and risk management lead to better outcomes over the long term. However, managing risk can be frustrating in the short run as the "Fear Of Missing Out" overrides common sense and logic.
If you disagree, that is okay.
When the opportunity presents itself, and the "madness has subsided," these are the questions we will ask ourselves before we add exposure to portfolios:
- What is the expected return from current valuation levels? (___%)
- If I am wrong, what is my potential downside, given my current risk exposure? (___%)
- What actions should I take now if #2 exceeds #1? (#2 – #1 = ___%)
How you answer those questions is entirely up to you.
What you do with the answers is also up to you.
We are all trying to answer the question, "How much of the 'narrative' already got priced into the market?"
By looking at the data, it would be easy to assume the answer is "much."
While bullishness indeed prevails at the moment, along with solid momentum in the market, this is a great time to set aside the narratives and return our focus to the basic portfolio management rules.
Rules For "Santa Rally"
If you are long equities in the current market, rebalancing risk is manageable.
Tighten up stop-loss levels to current support levels for each position. Hedge portfolios against major market declines. Take profits in positions that have been big winners Sell laggards and losers Raise cash and rebalance portfolios to target weightings. Notice, nothing in there says “sell everything and go to cash.”
Remember, our job as investors is pretty simple – protect our investment capital from short-term destruction so we can play the long-term investment game. Here are our thoughts on this.
Capital preservation is always the primary objective. If you lose your capital, you are out of the game. Seek a rate of return sufficient to keep pace with the inflation rate. Don't focus on beating the market. Keep expectations based on realistic objectives. (The market does not compound at 8%, 6% or 4%) Higher rates of return require an exponential increase in the underlying risk profile. This tends to never work out well. You can replace lost capital – but you can’t replace lost time. Time is a precious commodity that you cannot afford to waste. Portfolios are time-frame specific. If you have a 5-year retirement horizon but build a portfolio with a 20-year time horizon (taking on more risk), the results will likely be disastrous.
As discussed on Tuesday, there is a wide range of potential outcomes, based on valuations, in 2024. No one knows with any certainty what next year will hold. However, by focusing on risk controls and the technical underpinnings, we can safely navigate the waters to safety.
We are certainly anxiously anticipating the arrival of "Santa Claus." However, we remain keenly aware of the lessons taught to us in 2018 and 2020 that nothing is guaranteed.
