A failed Santa rally, now what?

Posted by Cam Hui -
Preface: Explaining our market timing models

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

 

The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.

 

 

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

 

 

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
  • Trend Model signal: Neutral (Last changed from “bullish” on 15-Nov-2024)
  • Trading model: Bullish (Last changed from “neutral” on 19-Dec-2024)

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent and on BlueSky at @humblestudent.bsky.social. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.

 

 

Santa has left for the year…

As I pointed out last week, the Santa Claus rally window is the last four days of the year and the first two days of the new year, and it’s one of the seasonally bullish periods of the year. History shows that a failed Santa rally often leads to subpar returns for the remainder of the year. The first day of the window was December 24 and the last day was January 3.

 

Santa has failed to call this year. The S&P 500 and the Dow closed above their respective Santa rally levels, though the Russell 2000 was marginally positive.

 

 

If adage about the Santa Claus rally is to be believed, the odds favour a subpar year in 2025 for the S&P 500: “If Santa should fail to call, the bears may come to Broad and Wall”.

 

 

 

Poised for a rebound

Before you turn overly bearish, you have to consider the short- and medium-term outlook. In the short term, the market remains highly oversold and poised for a rebound.

 

Even as the S&P 500 tests its recent lows, it’s flashing a series of positive divergences, as measured by its 5-day RSI, NYSE McClellan Oscillator, and NASDAQ McClellan Oscillator.
 

 

The latest bullish data point comes from the NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual client funds. A buy signal is issued whenever NAAIM falls below the lower 26-week Bollinger Band. The latest reading shows the index within a hair of that threshold, which I interpret to be close enough for a buy signal.
 

 

This indicator has shown a near 100% historical success rate in its track record. I interpret these conditions as the path of resistance for stock prices is up, at least in the near term.
 

 

The bull’s challenge

The key to the intermediate health of the bull market is its behaviour during the anticipated rebound. Walter Deemer recently voiced concerns that current technical conditions resemble the Nifty Fifty market top in 1972. This isn’t the dot-com bubble, when most of the bubble companies had no earnings. The AI-related stocks today have earnings and exhibit strong growth, much like the Nifty Fifty.

 

 

The warning in 1972, just as today, is showing up in the form of negative breadth divergences. Advance-Decline Lines, however they are measured, are all weaker than the S&P 500.
 

 

There are, however, some rays of hope.

 

The smaller stocks within the S&P 500, as well as the small-cap Russell 2000, are showing early signs of relative strength, which are indications of broadening breadth. If this trend were to continue during the anticipated rebound, that would give the bulls some hope that the top isn’t in yet.
 

 

Another constructive sign is the positive divergence exhibited by the junk bond market. The relative performance of junk bonds to their duration-equivalent Treasuries has reached a new high, even as the S&P 500 remains below its all-time high.
 

 

In conclusion, the Santa Claus rally didn’t come for stock investors this year. Perhaps he misread the calendar and confused it with the Julian calendar of the Ukrainian and Russian Orthodox Churches, which celebrates Christmas on January 7, though Ukraine switched its Christmas to December 25 to divorce itself from Russian traditions because of the war.

 

I believe investors need to consider short- and intermediate-term market conditions separately. Current market weakness has left the market poised for a reflex rally. The key to the intermediate-term outlook is the market’s behaviour during the anticipated rebound. Can breadth broaden out and more stocks participate on the upside?
Here are some questions to consider as the likely rebound develops in the coming days as ways to measure the health of the bull market:

  • Can the S&P 500 and Russell 2000 break out through the (dotted) falling trend lines?
  • How will each index behave if they reach the top of their respective trading ranges?
  • Can the small cap Russell 2000 outperform, which would be a constructive sign of broadening breadth?

 

 

Stay tuned.

 

My inner trader continues to hold a long position in the S&P 500. 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

 

Trump’s messy governing challenges

Posted by Cam Hui -
The year started with a bang. Investor hopes were high on the expectation of the implementation of Trump’s pro-business and pro-growth policies, but stock prices struggled and ended last week in the red.

 

According to FactSet, the bottom-up aggregated S&P 500 target price for year-end 2025 is 6,678.18. But in the last 20 years, bottom-up analysts have historically overestimated the S&P 500 year-end price by 6.9%. Applying the 6.9% discount we would arrive at an adjusted target of 6,084.19, which represents a price gain of 5.7% for the year.
 

 

The FactSet adjusted estimate is roughly in line with my expectation of low single-digit gains. Along the way, however, I expect a higher degree of market volatility during the year as the Trump 2.0 Administration takes office and faces the challenges of governing.
 

Here’s why.
 

 

The challenges of governing

Donald Trump was elected as a disrupter. Washington needed to be disrupted, and Trump was the man to do it. However, the details of disruptions were less clear. In many ways, we can draw an analogy with Brexit. Brexit was seen as a new order for Britons, though there was no consensus on the actual details of Brexit implementation. The reality of Brexit turned out to fall short of the expectations of most Brexiteers.
 

In the same fashion, Trump will have to face the challenges of governing.

 

The recent dispute within the Republican Party over the H-1B visa is an illustration of the hard choices of governing. For readers who are unfamiliar with the H-1B visa, employers apply for H-1B work permits for overseas skilled workers, but those workers are severely restricted from leaving their employers once they landed on U.S. soil. Employers argued that there was a lack of trained U.S. personnel to fill open positions. Trump’s electorate base argued that the H-1B undercut American workers. The truth was somewhere in between. There is a lack of qualified skilled workers at a price, and H-1B visas helped employers, which are mostly technology companies, to improve their margins with lower labour costs.
 

In the end, Trump sided with the employers.
 

 

 

Legislative challenges

As Trump takes office on January 20, here are some of the challenges facing him.

 

The most immediate challenge was the election of a Speaker of the House. The current speaker, Mike Johnson, faced a number of challenges to his position. The Republicans hold a 219–215 majority. Rep. Thomas Massie (R-Ky) has actively opposed Johnson, which means that one more Republican defection would sink Johnson’s leadership. In the end, Johnson won the speaker’s gavel on the first ballot after some extensive negotiation. This was a test that turned out to be bullish for the Republican legislative agenda, but the risk of a Party revolt was extensive.

 

The next urgent issue facing the government is the debt ceiling. Trump had hoped that the last-minute continuing resolution deal in December to avoid a government shutdown would extend or eliminate the debt ceiling, but his hopes were dashed. On December 27, Treasury Secretary Janet Yellen wrote to Congress and warned, “Treasury currently expects to reach the new limit between Jan. 14 and Jan. 23, at which time it will be necessary for Treasury to start taking extraordinary measures.”

 

In the short run, Treasury’s “extraordinary measures” are equity bullish, as it draws down the funds in the Treasury General Account held at the Fed. This has the effect of writing cheques and injecting liquidity into the banking system, which is bullish. If the debt ceiling dispute isn’t resolved in reasonably short order, the market will start to price in the tail-risk catastrophe of a U.S. Treasury default.
 

 

 

Bessent’s Challenges

As well, incoming Treasury Secretary Scott Bessent faces the challenge of re-financing about 30% of the $28 trillion of the Treasury’s outstanding debt. The Yellen Treasury adopted the position of issuing a greater mix of short-term T-Bills, which are effectively floating rate paper, compared to fixed-rate coupon paying Treasury Notes and Bonds. As rates have risen over the past few years, the reliance on short-term financing has increased the Treasury’s interest burden.
 

 

Bessent has promised to remedy the situation by borrowing longer term. But the issuance of long-term debt has the short-term effect of draining liquidity from the banking system. To explain, imagine an investor has the option of investing in short-term paper, which he can draw on relatively quickly, or lock up his money in a long bond, which is less liquid and comes with price risk. As a result, a greater pool of short-term Treasury paper encourages higher banking system liquidity, which is equity positive.

 

A Bloomberg article, “Treasury’s Elite Bond Dealers Will Struggle to Handle $50 Trillion Debt”, outlined the extent of the challenges facing the new Treasury Secretary. One stark example occurred last September, when Citadel Securities announced in September that it declined to join the group of Treasury primary dealers, which makes a market and bids on newly issued Treasury securities. Bloomberg reported that heavy issuance was putting strains on primary dealer operations:

“Issuance has gone up almost threefold in the last 10 years and the anticipation is for it to close to double to $50 trillion outstanding in the next 10 years, whereas dealer balance sheets haven’t grown at that magnitude,” said Casey Spezzano, head of U.S. customer sales and trading at primary markets dealer NatWest Markets and chair of the Treasury Market Practices Group, the government-debt watchdog sponsored by the New York Fed.

 

 

Macro headwinds

Trump’s policy challenges could have the effect of distracting the incoming administration from implementing its equity friendly policies of tax cuts and deregulation. In addition, stock prices face a number of macro challenges in the year ahead.

 

First, disinflationary progress appears to be stalling. The inflation expectations factor, as measured by a long TIPS ETF and short long zero-coupon Treasury ETF, is breaking out to new recovery highs. The Fed may soon face a difficult decision of either accepting a higher 3% inflation rate or raising interest rates.
 

 

At the same time, economic growth may be stalling as the U.S. Economic Surprise Index has declined in the past few months. While these readings are not recessionary, they do raise the risk of either stagflation or recession scares later in the year. Decelerating economic growth rates also translate into falling earnings growth rates, which is equity bearish.
 

 

These macro risks are occurring against a backdrop of an elevated forward P/E ratio. The S&P 500 is priced for perfection, or near perfection.
 

 

In conclusion, I reiterate my belief that in the absence of a recession the S&P 500 should register low single-digit gains for 2025. However, the emergence of policy implementation risk by the incoming Trump Administration makes me believe the market will experience several volatility shocks during the year. Be prepared for a choppy but mildly positive year for stock prices in 2025.

 

So much for December seasonality

Posted by Cam Hui -
Mid-week market update: I reiterate my belief that while seasonality is informative of climate, it is not a forecast of the weather ahead. 2024 was a difficult year based on seasonal patterns, as depicted by Jeffrey Hirsch of Almanac Trader.

 

 

Instead, the stock market was weak in the second half of December and small caps leadership did not emerge during that period. That said, the S&P 500 ended to year right at trend line support and the NASDAQ 100 ended the year at 50 dma support.

 

 

 

Positive divergences

I can find several silver linings in the dark cloud of market correction. First, the market achieved a severely oversold condition reminiscent of the October 2023 bottom and the COVID Crash. While a V-shaped recovery did not appear as expected, subsequent weakness revealed a series of positive divergences as the S&P 500 tested its recent lows, such as this one from the Fear & Greed Index.

 

 

As well, small cap relative performance started to turn up in the last few days, which is a constructive development indicating broadening breadth.

 

 

We can see the a similar effect in the value and growth relationship. Value rebounded against growth across all market bands in late December.

 

 

 

Historical studies

I hate to bring up historical studies of similar episodes because of their small sample sizes. Wayne Whaley highlighted that 2024 was the worst last week of December since 1937. He found that there weren’t many cases of a double digit year finishing with a 1% last week loss. In those four cases, the following week in January was resolved in strong rebounds, though January returns were lacklustre.

 

 

Ryan Detrick found only five cases of three consecutive down days to end the year. In all cases, the market rebounded strongly 100% of the time.

 

 

It’s difficult to forecast what 2025 will look like for investors. However, I am reasonably constructive that the stock market is poised for a short-term rebound. The S&P 500 Intermediate-Term Breadth Momentum Oscillator is on a buy signal setup, and the buy signal will trigger once its 14-day RSI recycles from oversold to neutral. As well, the percentage of S&P 500 above its 20 dma remains highly oversold. While oversold markets can become more oversold, I haven’t seen any fundamental catalyst to spark another downleg. I therefore conclude that the odds favour an upside move in the near future.

 

 

My inner trader is holding on to his long S&P 500 position. 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

 

Contrarian bargains among Santa’s discards

Posted by Cam Hui -
Preface: Explaining our market timing models

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

 

The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.

 

 

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

 

 

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
  • Trend Model signal: Neutral (Last changed from “bullish” on 15-Nov-2024)
  • Trading model: Bullish (Last changed from “neutral” on 19-Dec-2024)

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent and on BlueSky at @humblestudent.bsky.social. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.

 

 

If Santa should fail to call…

The Santa Claus rally window is the last four days of the year and the first two days of the new year, and it’s one of the seasonally bullish periods of the year. History shows that a failed Santa rally often leads to subpar returns for the remainder of the year. The first day of the window was December 24. So far, the market has performed well this year.

 

There is an adage among traders: “If Santa should fail to call, the bears may come to Broad and Wall”. If the advance continues, the risk of a major bear market in 2025 is diminished though.
 

 

So far, the question of whether Santa Claus will appear this year is a toss-up. It is constructive that Friday’s S&P 500 decline bounced off the 50 dma. While the S&P 500 closed marginally below the December 23 close, which is the Santa Claus rally starting level, both the Dow and Russell 2000 closed above their respective Santa rally levels.

 

 

 

Narrow leadership

Nevertheless, the rebound should continue as the advance began from deeply oversold conditions. In the past, such rallies didn’t stall until most of the overbought/oversold indicators reached overbought levels.
 

What’s unusual about the initial rebound is the narrow leadership. Market breadth isn’t broadening out during the relief rally.
 

 

The animal spirits don’t seem to be participating. The performance of IPO stocks, which is an indicator of speculative activity, is lagging the market.
 

 

 

Contrarian opportunities for the bulls

These conditions set up two possible outcomes. Either the rally fails and the market corrects in January or leadership rotates to the lagging groups of the market. With that in mind, here are some selected contrarian opportunities for bulls or investors who want some equity exposure. These highlighted opportunities trade at single-digit forward P/E ratios, which is rare in an environment when the S&P 500 trades at a forward P/E of 22. As well, each of these stocks exhibited weakness in December, which may be attributable to year-end tax loss selling and sets up the potential for a January rebound.

 

I produce a monthly LBO screen of non-financial stocks within the S&P 1500. For a full description of my methodology, please see my original publication, How To Buy A Company If You Have No Money. As a reminder, I calculate a LBO price target range based on two techniques to estimate cash flows: based on normalized EBITDA margins as applied to current sales and EBITDA based on consensus forward 12-month EPS.
I found 35 stocks that qualify under my LBO criteria of 30% down which is an increase from 29 last month. Funding costs have been steady. The increase can be attributed to the combination of the underperformance of small-cap stocks, which have lagged large caps even within the technology sector, and the underperformance of energy stocks, which are appearing on my LBO screen in increasing numbers.

 

I highlight three selected opportunities among the possible LBO candidates, with the caveat that a deep value screen like the LBO should be used by investors to identify stocks for further detailed fundamental analysis as there is a heightened risk of value traps in many of the names. This is not a quantitative factor that can be blindly bought because of the high degree of stock-specific risk which will be difficult to diversify away.

 

Centene hit a 52-week low in December and passed my LBO screen on the basis of low volatility of its margins, which allow for higher debt levels, single-digit forward P/E and sizeable cash position.

 

Lear Corp. could be attractive for contrarian value investors. It appears on my LBO screen based on its strong cash position and steady margins. In addition, its single-digit forward P/E ratio adds to its value as a potential bargain.
 

 

Another recurring theme that I found among the LBO stocks is energy. Consider Peabody Energy. This coal stock shows a relatively large cash position and strong cash flow. Peabody Energy is a deep value recovery candidate that’s trading near the top of its LBO range.
 

 

The relative attractiveness of the energy sector is underlined by the continued accumulation of Occidental Petroleum by Warren Buffett’s Berkshire Hathaway. Occidental’s stock price is now at or below Buffett’s original purchase levels.
 

 

Are you prepared to be contrarian?

 

In conclusion, the stock market is likely to advance during the Santa Claus rally window, which began on December 24 and ends January 3. But the rally is attributed to an oversold bounce and marked by narrow leadership. Either the rebound fizzles in January or broadens into lagging issues. I identified selected contrarian value opportunities for bulls among Santa’s discards for potential outperformance into January and beyond.

 

As a reminder, a deep value screen like the LBO should be used by investors to identify stocks for further detailed fundamental analysis as there is a heightened risk of value traps in many of the names. This is not a quantitative factor that can be blindly bought because of the high degree of stock-specific risk which will be difficult to diversify away.

 

My inner trader continues to hold a long position in the S&P 500. 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

 

Estimating downside risk

Posted by Cam Hui -

I have warned about excessive valuation before (see 2025 Outlook: Cautious But Not Bearish). The S&P 500 is trading at a forward P/E of 22, which is elevated by historical standards. On one hand, valuation isn’t highly predictive of returns over a one-year horizon. On the other hand, elevated P/E ratios lead to lower returns over a five-year time horizon.
 

 

In other words, valuations don’t matter until they matter. As investors look ahead into 2025 against a backdrop of a high P/E market, one key question is: “What’s the downside risk in the event of a bear market?”
 

 

A giddy backdrop

Callum Thomas of Topdown Charts highlighted the frothy nature of the market today. IBES is known for its compilation of analyst earnings estimates. In addition to the well-known consensus FY1 and FY2 EPS estimates, IBES also publishes a long-term EPS growth estimate. As the accompanying chart shows, long-term growth estimates have reached the giddy levels similar to the dot-com bubble top.
 

 

The combination of elevated P/E valuation and extremes in earnings growth expectations makes the U.S. equity market vulnerable to a setback.
 

 

Sources of vulnerability

What could make stock prices fall? What if the Magnificent Seven growth were to slow?

 

To be sure, the stock market is rationally exuberant owing to the earnings growth of the Magnificent Seven compared to the rest of the 493 stocks in the S&P 500 (see Equity Return Expectations Under an Alien Invasion). On the other hand, this makes the market highly vulnerable to Magnificent Seven earnings disappointment. At a minimum, the gap in earnings growth expectations between the Magnificent Seven and the S&P 493 is expected narrow in 2025.

 

 

In addition, the stock market isn’t cheap even outside of the Magnificent Seven. Combined P/E ratios are equally elevated outside of TMT (Technology-Media-Telecom).

 


 

From a top-down perspective, the emerging divergence between the U.S. Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, and the 10-year Treasury yield is worrisome.

 

The divergence is especially concerning as the inflation expectation trade is heating up.
 

 

If inflation expectations rise and push up yields, it would put downward pressure on P/E ratios.
 

 

Estimating downside risk

As the Magnificent Seven is a source of major vulnerability for the S&P 500, here is one way of estimating downside risk. An analysis of the limited history of changes in peak and trough P/E ratios shows that the median tech P/Es fell from 29.5 to 13.1, which is over 50%, though that doesn’t represent actual price risk because earnings will rise during the bear market. Nevertheless, a ballpark estimate of price risk in technology stocks should the AI bubble burst would be about 50%.
 

 

As the Magnificent Seven represents about 32% of the weight of the S&P 500, this translates into about 15% downside risk for the overall index. The 15% downside is a minimum estimate, as the S&P 493 would likely decline as well. Assuming a lower beta in the S&P 493 during a price decline, we estimate bear market downside risk at 20–30% for the S&P 500.

 

 

Watching for bearish triggers

Despite my valuation concerns, I see no immediate bearish triggers for stock prices. High yield funding proxies, such as the junk bond spread plus a five-year Treasury yield, and actual junk bond yield levels (blue and red lines) are not showing signs of excessive funding stress. I consider junk bond funding a sensitive canary in the coalmine of equity fund costs, which needs to be closely monitored.
 

 

I am also keeping an eye on the Advance-Decline Line, which is showing a minor negative divergence against the S&P 500. Historically, A-D Line divergence have lasted for months before major tops of the market.
 

 

In conclusion, the U.S. equity is highly vulnerable because of overvaluation and excessive growth expectations, but valuation is not very predictive of returns over a one-year time horizon. I estimate downside risk on the S&P 500 in the 20–30% range in the event of a major bear market. Despite my concerns, I see no immediate bearish triggers for investors to adopt defensive positioning in their portfolios.