Schaeffer's 43rd Anniversary Stock Picks in 2024

How the Fed Stole the Santa Claus Rally

Santa could still show up for stocks, but time is running short

Senior Vice President of Research
Jan 2, 2018 at 8:32 AM
facebook X logo linkedin

The books for 2017 are closed, but as we move into 2018, loyal readers of Monday Morning Outlook are fully aware that the year-end closing levels on major equity, volatility, commodity, and currency benchmarks -- along with their related exchange-traded funds (ETFs) -- could serve as key potential support and resistance levels. This could be the case at least early in 2018, and maybe throughout the year. With that said, the table below displays 2017 closing levels for several indexes and ETFs that you can use as a reference.

2017 closing index and ETF levels

"Stocks have declined the first two days of the seven-session Santa rally span that began Dec. 22 and ends Jan. 3. The good news is stocks tend to rise in this seven-day stretch. The Standard & Poor's 500 stock index has posted an average gain of 1.7% and gone up 78% of the time since 1928, according to data from Oppenheimer, a Wall Street firm. The bad news is when stocks don't rise during these seven days, performance tends to be weak in the months ahead. In fact, the S&P 500 was down 1.2% three months after a negative return during the Santa rally period."
    -- USA Today, December 27, 2017

The excerpt above refers to the popular "Santa Claus" rally, referring to the bullish stock market bias that begins with the last five trading days of the calendar year and ends with the first two days of the new year.  Whether you are a small-cap investor, large-cap investor, or both, Santa has yet to appear -- but still has two days to do so.

The S&P 500 Index (SPX - 2,673.61) would have to finish above its Dec. 21 close of 2,684.57 to constitute a profit during this bullish period, but would need to rise above 2,730 at Wednesday's close to experience a "Santa Claus" gain that matches its historical average. Meanwhile, the RUT would have to close above 1,547.11. For bulls, there is still time for Santa Claus to arrive as defined by the official time frame, but time is running out.

From a seasonality perspective, there is hope for the bulls, with New Year's week having a historically bullish seasonality. Below is a table that Schaeffer's Senior Quantitative Analyst Rocky White created for his "Indicator of the Week" column on Dec. 20.

spx during christmas and new years weeks

"The Monday close of $268.20 was just 3 hundredths of a point shy of the $268.23 level that is exactly 20% above the SPY's 2016 close... Seasonality favors stocks. However, after a mid-December Fed rate hike, a lackluster response to the passage of a tax bill that slashed corporate tax rates, key benchmarks failing at resistance levels, and a bearish divergence in the Relative Strength Index (RSI) of the SPY, RUT, and IXIC, signs point to a grind for both bulls and bears in the immediate weeks ahead. While bears may be happy to see a lackluster reaction to the tax bill headlines, it is also important to note that there was not nearly enough selling pressure to push key benchmarks below support -- such as IXIC 6,850, RUT 1,500, or SPY 250."
    -- Monday Morning Outlook, December 26, 2017

With Santa yet to arrive, the Fed might be labeled as the Grinch that is stealing Santa's thunder, following its (expected) Dec. 13 rate hike. I have observed numerous times that during the current rate policy-tightening cycle, even when a hike was expected, stocks have tended to underperform in the month following such a move. And per the table below, note that after rate hikes in December 2015 and December 2016, the Santa Claus rally fell well short of expectations.

I should mention, as you review the table, that the Fed played the role of "Santa" in December 2008 by reducing the fed funds rate on Dec. 16 from 1.0% to 0.25%.  The 75-basis point cut preceded a 7.45% rally in the last five trading days of 2008 and the first two trading days of 2009.

spx santa claus rally since 2008

There has been a clear loss of momentum in recent days. For example, in the 12 days preceding the rate hike, the SPX rallied 2.4%. In the 12 days following the rate hike, the SPX has advanced 0.6%. The advance comes despite a 1.0% move higher on Dec. 18, when it became evident that lower corporate tax rates were going to be signed into law before Christmas. The SPX hasn't made any headway since Congress voted tax reform into law and President Trump signed the legislation, and the index comes into 2018 trading only about 11 points above its Dec. 13 "rate hike-day" close.

Coincidentally, the levels that are a round 20% above the SPX and SPDR S&P 500 ETF Trust (SPY - 266.86) 2016 closes -- 2,686.60 and $268.23 – have been areas of resistance during the sideways action that has mostly defined the second half of December. Meanwhile, the RUT has met resistance at the 1,550 half-century mark since late November. This is no major surprise, as this index has historically respected century levels as support, resistance, or hesitation areas.  Moreover, the tech-heavy Nasdaq Composite (IXIC - 6,903.39) has toyed with the round 7,000 level since the Dec. 18 rally, but still has yet to close above this round millennium mark.

I am still expecting a Fed-induced grind for at least the next couple of weeks, and risks to the downside grow if stocks close back below the mid-December Federal Open Market Committee (FOMC) day closing level around SPY $266.75.

However, in addition to the longer-term trend, the risk to the bears is the possibility of a short-covering rally. Per the graph below, the shorts on SPX component stocks are not exactly building positions anymore, but they haven't exactly panicked out of positions. A decline in short interest, like that which occurred around this time last year, could have a hugely positive impact if market participants fully digest the most recent rate hike and move back into equities.

spx short interest 1229

Anecdotally, it appears strong financial stocks and a weak dollar are a consensus theme heading into 2018. If price action or events that impact these areas move opposite these consensus opinions, there may be opportunities to play the unwinding of these trades.  

And from a broader perspective, pay attention to consensus opinions that emerge for 2018. Some of them will play out as expected, but the rewards come with increased risk of being in a crowded trade. I once again advocate using options, if choosing to go with the crowd, as a risk-management tool. Other themes will turn out dead wrong, and those will present the biggest opportunities with less risk.

The best of luck to you in 2018.  Thank you again for reading Monday Morning Outlook.

Continue reading:


A.I.’s Dirty Little Secret: The Real Power Behind The AI. Boom ✨

Anyone who’s seen the The Matrix movies knows that A.I. needs power.  Lots and lots of power.

If you’ve seen the movie, you also know the grizzly results of the ensuing battle for that power.

Now, Wall Street’s battle for A.I. power won’t go to such extremes. Hopefully?

A.I. needs more power and that means more opportunities for stock traders in the know.

Download your free copy of “The A.I. Revolution: 4 Stocks to Buy Now”!