Many investors still believe in the Santa Claus rally. Why not? It is a phenomenon that happens more often than not. The Santa Claus rally usually happens during the week between Christmas Day and New Years Day. What is the reason behind this rally? Is it because a lot of investors are more cheerful around the holiday season? Perhaps, it is due to tax considerations. Right? While I would like to believe that the holidays spirit is driving this rally, I don’t believe this to be the case. Additionally, If it were due to tax considerations, then stocks would decline as investors sell losing stocks to lock in the loss. Therefore there has to be another logical reason behind this phenomenon. The answer lies with institutional investors. The rally is driven primarily by asset managers that are window dressing. Most asset managers have to report their positions on December 31, the end of Q4, to their investors. Therefore, most asset managers rebalance their book by purchasing popular names (AAPL, AMZN, etc.) to help boost the perception that they are clever investment managers.
If there is a Santa Claus rally, then what should we expect after December 31? A New Year’s Hangover. These short-lived investment catalysts will results in pain for those short-term traders. As Dan Nathan said, “the Santa Rally can quickly become a New Year’s Hangover.” At this point, the S&P 500 is up 1% for the year and most think it’s safe to assume that the most likely outcome is that the index will close up or down a few percentage point points by the end of the year. Who knows what will be in store for January.
What happened in November?
Despite volatile swings, November was largely lackluster as the major averages were flat for the month (and for the year!) as traders were trying to determine where the markets will go for the end of the year. The emerging market economies have begun to make headlines again lately as the Chinese, Brazilian, and Russian equity markets have again been showing signs of stress. Brazil’s Bovespa is down nearly 8% from its one month high, China’s Shanghai Composite is down 6% from its one month high and Russia’s RTS is down 7% in the last week. Some believe that this is due to the strong dollar, others believe it is due to slowing demand, and others see it as the western world slowing down their debt accumulation (or even deleveraging). I believe it is a combination of the three viewpoints, with a larger weighting on slowing debt accumulation. If we think of consumption as function of supply and demand, then the accumulation of debt will certainly drive consumption higher. It is no secret that the U.S. and Europe has been deleveraging for quite some time. As the growth of debt decreases, then consumption will certainly slow as a result. I personally believe that this is the main factor behind the slowing global economy.
(Annual Changes in Household Debt – www.federalreserve.org)
Here in the U.S., mixed data continues to drive a divergence between the bulls and the bears. The 12 mo. change ISM Manufacturing Index (an index that monitors U.S. manufacturing) surprised with a very weak report earlier this week, showing another contraction and printing its lowest figure since April 2009.
Though, auto sales continue to drive toward record figures, backed by cheap gasoline and low financing costs. November’s figure of 1.3 million vehicles is a 14-year high.
Corporate bonds are showing a cause for concern. Most investors agree that the bond market can be a great leading indicator for the stock market. A divergence between the high yield market and the S&P 500 usually means that the high yield market can sense economic stress better than the stock market. If this is true, then stock investors should be getting jittery.
What about December?
The biggest news this month, of course, the Fed’s decision. With today’s November jobs report (211K jobs created vs. 200K expected), it is pretty much a guarantee that the Fed will raise interest rates on December 16th, (barring any unforeseen negative events). This will be the first rate hike in nearly 9 years (2006!). Nobody knows how high the hike will be, or if the Fed will continue to raise rates thereafter. Though, Charles Evans, the president of the Chicago Fed, said that he is nervous about the upcoming policy decision. Remember, the biggest reason why the Fed has delayed a rate hike is due to the lack of inflation. Why is Evans fearful? If the Fed misjudges the strength of the economy or the upward tilt in inflation, then the Fed would have to reverse their policy stance and cut interest rates back to zero and/or implement unorthodox policy tools, such as Quantitative Easing. The Fed has been good about communicating the possibility for a rate hike. But, by doing so, the Fed has baked itself into a corner. If the economy is not strong enough for a rate hike, it would be extremely difficult for the Fed NOT to raise interest rates in a few weeks.
Finally, the US is likely to experience an earnings recession after a 1.6% decline in earnings for the 3rd quarter. It would be the first back-to-back quarters of declining earnings since 2009. Furthermore, corporate profit margins have been declining since the beginning of this year. This usually coincides with a recession.
In closing, I still hold my position that risk is abnormally high and it pays to be defensive in this environment. If there is a Santa rally, then the hangover in January will likely counteract any of those gains. As such, all of the Bull Oak portfolios are continuing to hold their defensive positions until equities are more reasonably priced.