“Santa Claus” rallies, holiday back-and-forth market activity, and trying to figure out how you’re going to fit everyone’s cars in your driveway this weekend are only a few of the concerns traders are faced with as we head into Christmas.
Still erring on the side of caution, we do however see that some new risks may pose some unexpected profit opportunities.
Starting across the ocean in Japan, the trickle-down effect of some recent activity has some interesting effects on stocks.
Here’s what we mean…
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What’s Going On Overseas
This might get a little confusing for a moment, but bear with us.
The Bank of Japan (BOJ) made a major move on Tuesday by increasing the cap on the 10-year Japanese government bond yield from 0.25% to 0.50%. (This is different than what the Fed is doing by hiking the overnight target rate, but the effect is similar. Raising bond yields increases the cost of capital.)
The BOJ made the move to start normalizing monetary policy, but we don’t know what “normal” monetary policy is for the BOJ. The Japanese central bank has been the most aggressive at lowering rates and keeping them low among developed economies since its own asset bubble collapse in 1991.
To put this in perspective, the BOJ has only hiked rates twice since 1990 – in 2006 and 2007 right before the global financial crisis. Talk about bad timing…
To be fair, we would have to say that the BOJ’s “normal” monetary policy is to stimulate with low rates. So, the move this week was a huge surprise and caught economists and traders off guard. As you can see in the following chart, the USD lost 4% against the yen on Tuesday.
So, what’s this have to do with stocks?
As you know, when the Fed raises rates, the cost of borrowing rises.
This is one of the reasons the homebuilder market in the U.S. is doing so poorly. This is also true for the yen. Rising rates means loans in yen terms are more expensive, especially if they have been used for short-term financing.
Over the last several years, investors around the world have been borrowing yen at very low rates in order to buy higher-yielding assets like U.S. stocks. When the yen is cheaper, borrowing is even easier, and this benefits those other assets. In other words, a strong yen is bad for U.S. stocks.
The correlation between a stronger yen and falling stock prices isn’t perfect, so don’t panic about this week’s surprise yet.
However, the two assets move together closely enough that this is a trend we should monitor closely. For example, the yen has been rising since the BOJ started propping it up on Oct. 21 and stocks have been unable to break trendline resistance over the same period – the S&P 500 failed again after two attempts to break resistance over the last two weeks.
A Santa Claus Rally?
Has a rising yen and a hawkish Fed eliminated the possibility of a “Santa Claus” rally? We have had a lot of questions about that this week, and the answer is the Santa Claus rally is not a real thing; it’s just something that financial journalists talk about because it’s fun and attracts readers.
The Santa Claus rally is loosely defined as a likelihood for stock prices to rise the week before and/or the week after Christmas. However, a historical analysis of those weeks shows the market is as likely to rise then as any other two-week period during the year.
We think the real question traders should ask is whether the market will find support before the end of the year (support, as you recall, means a steady level that any given security does not fall below).
From a technical perspective, we think the odds for a pause at support are high. As you can see in the following chart, the S&P 500 broke short-term support near 3,900 last week after the Fed’s rate decision. However, the 3,800 range is still intact, and we expect that level to hold in the short term.
In our view the worst-case scenario is a drop back to the prior lows near 3,600 on the S&P 500. Positive surprises from
FedEx Corp. (FDX) and Nike Inc. (NKE) this week have confirmed that consumer and business spending is still relatively strong. While we don’t think the market will break out to new highs, these reports increase the chance that support will hold, and we won’t see prices at or below 3,600 for a while.
Bottom Line
The week before Christmas and the one in between Christmas and New Year are usually very quiet.
Volume tends to be the lowest of the year, and unless there is a bigger surprise in store, we plan to look for opportunities to add a little risk to the portfolio (and more income) on the dips to support.
As we saw with the most recent labor reports and Tuesday’s earnings report from NKE, consumption and hiring are still strong. It may be a while before a new bullish trend emerges but a bounce back up to trendline resistance in early January seems likely.
Sincerely,
John and Wade
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