Will we see the Santa rally this year?

Posted by Cam Hui -

Mid-week market update: The recent stock market rally has been astounding. Sentiment readings on the Fear & Greed Index surged from extreme fear in October to extreme greed in less than two months. While extremely fearful sentiment can be useful buy signals, extreme bullish sentiments are condition indicators and inexact sell signals. This leads to the tactical conclusion that it’s too late for investment-oriented accounts to be adding risk. Bulls should wait for a likely pullback for a lower-risk entry point.
 

 

Publication note: There will only be one publication this weekend showing the model readings with a brief commentary. There will be no mid-week market update next week barring unforeseen volatility. The regular publication schedule will resume the weekend of January 30.
 

 

Respect the breadth thrust

Even though the market appears to be overbought, investors should keep in mind that these conditions are appearing against a breadth thrust backdrop. Consider how the percentage of S&P 500 stocks above their 50 dma surged from below 10% to over 90% this week. Such overbought conditions can be interpreted two ways. First, these are instances of strong price momentum that signal bull markets. On the other hand, they have also resolved in short-term pullbacks that can be good buying opportunities.
 

 

The 10-year history of the Zweig Breadth Thrust Indicator (bottom panel) tells a similar story. As a reminder, a ZBT buy signal is triggered when the ZBT Indicator rises from oversold to overbought within 10 trading days, which is a rare occurrence. That said, the market has flashed a cluster of ZBT Indicator overbought conditions and past instances were indicators of strong market momentum. In other words, these are “good overbought” signals.
 

 

This market advance has been accompanied by broadening breadth. Willie Delwiche pointed out that the percentage of industry groups making 13-week highs is at its highest since June 2020, which is another sign of price momentum and broadening participation.
 

 

 

Santa rally ahead

The official “Santa Claus Rally” season is the last five days of the year, or December 22, and ends on the second day of the new year and it is seasonally positive for equities.
 

 

Wednesday’s downdraft in prices reset the 14-hour RSI of the S&P 500 to its target of below 50 after breaching the 90 level. If the recent past is any guide, this should represent a welcome entry point for nimble traders to position for a potential Santa Claus rally.

 

 

Small-cap stocks, which have been the laggards in 2023, have tended to outperform during that period, and small caps are attempting breakouts through resistance. Upside breakouts during this seasonally strong period could signal even more upside potential.
 

 

Tactically, I believe small caps, and especially low-quality small caps, have the potential for strong gains during the Santa Claus rally period. I recently highlighted the reversal of the crowded equity hedge fund trade of long Magnificent Seven and short small caps and low-quality names. Keep an eye on the behaviour of the equity market-neutral ETF BTAL as a proxy for equity hedge fund factor exposure. Even though many hedge funds have closed down their trading books for the holiday season, their incentive fees are determined at the end of the year. If they haven’t flattened their books, further reversals of the small-cap and low-quality factors will force traders to chase these names in a short-covering rally. The price response of these stocks would be especially exaggerated during a period of low liquidity.
 

 

 

Too early to short

I have had discussions with traders who have shown some eagerness to short this overbought market. My advice is to wait for the sell signal before entering a short position. You don’t want to be caught short during a seasonally strong period.

 

Option sentiment models are nearing a sell signal, but they’re not there yet. The 10 dma of the CBOE put/call ratio and the equity-only put/call ratio are still above their one-standard deviation Bollinger Bands. A breakdown through these levels would be signals of imminent market weakness. Just not yet.
 

 

In conclusion, the stock market is overbought and sentiment models are reaching bullish extremes. However, price momentum is strong, indicating long-term bullish outlooks. Similar overbought conditions have resolved with short-term pullbacks. Investors who are under-invested should wait for weakness for a better long entry point.

 

Both my inner investor and inner trader are bullishly positioned. The usual disclaimers apply to my trading positions:

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

 

 

Disclosure: Long SPXL