Has Santa Claus Left Town?

The Santa Claus rally lasted just about to the end of December, and then began to fall apart with the start of the new year. It often feels like market trends don’t have the longevity they used to have, but in reality, the effect we see is simply a ‘reversion to the mean’. While the long term market trend is up, over shorter periods, the stock market has a hard time moving too far away from the mean and is naturally drawn back to the mean over time.

The chart below tells the story. The purple line is the S&P 500 index, using weekly data over the past 5 years. The orange line is the 20-week simple moving average. Markets deviate from the mean, both up and down, and sometimes by a lot, but always get pulled back. The further from the mean, the more likely a market turn is in store. The Santa Clause rally took us from far below the mean to far above the mean in short order. And with the open of the new year, the stock market seems poised to head back toward the mean once again.

The swings above and below the mean are explained by investor behavior. Good news typically brings excessive investor enthusiasm, and markets overreact on the upside. Likewise, bad news brings excessive doom and gloom, and markets overreact on the downside. In all cases, markets are eventually brought back to reality, and that is seen visually by a reversion to the mean. A quick look at a chart like this can give a hint about what is to come in the short run.

In the histogram below, we have used the same weekly data to plot where the S&P 500 index was relative to the 20 week moving average. Here’s how to read the histogram. Take a look at the tallest bar on the right side of the chart, labelled “35”. On the x-axis, that bar is labelled “6%, 7%”. That means that in the five year period of weekly data we examined, the S&P was 6% to 7% above the mean on 35 occasions (out of a total of 262 observations).

In the third week of December, the S&P 500 Index peaked at about 7.1% above the 20-week moving average. Over the five year period, the Index exceeded the moving average by more than 7.1% only 11% of the time. The clear implication is that the Santa Claus rally is nearing excessive levels and may be due for a break. Unsurprisingly the new year has gotten off to a relatively weak start. As of early Friday afternoon, the Index had retreated to about 5% above the moving average, still fairly high, but not nearly as excessive. The next stock market move is anybody’s guess, but odds would say it moves a bit lower. As my father used to say, that, and a token, will get you on the subway.

Fundamentally, there were good reasons for the change in market direction. The Fed, which had been steadfast in talking like the next rate move could be higher, unexpectedly changed course in mid-December and the median expectation of the FOMC switched downward to now expect three, ¼% rate cuts in 2024.

Markets, of course, are very efficient at quickly taking new information into account and they changed course. But markets are much less efficient in determining the magnitude of the change. By the time year-end arrived, the bond market was expecting six ¼% rate cuts in 2024 and the stock market was equally exuberant. Here is something to think about:

  • Six rate cuts in the span of a year would be a very rapid decline. The Fed would only cut rates sharply if something ‘bad’ were happening, like a financial disaster, a recession, or something of that sort. It was only a few years ago when the Fed cut rates at an even faster pace as they addressed the impact of the pandemic in the Spring 2020. A financial disaster would not be good for stocks, so we need to be careful what we wish for.
  • The Fed projections included three rate cuts in 2024 and three to four more cuts in 2025. If the Fed is anywhere close to being correct, the stock market was already discounting the 2025 rate cuts too. That simply makes no sense as there is so much that can happen in between that simply cannot be anticipated.

The Santa Claus rally was massive and quick, but appears that the stock market has over-reacted (again). In just the first week of 2024, interest rates have returned to higher levels and rate cut expectations are diminishing. The magnetic power of the mean appears ready to take its toll in early 2024. But fear not, in baseball terms, this is the top of the first inning. We have a long way to go.

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By: Adam