The 'Santa Claus rally' defined and the chances it occurs this year on Wall Street

Will there be a Santa Claus rally? The bulls say yes.

The Santa Claus rally is a very specific event. It is the tendency for the market to rise in the last five trading days of the current year and the first two days of the new year. First discovered by Yale Hirsch of "Stock Trader's Almanac," it has produced positive returns 34 of the past 45 years for an average return of 1.4%.

The problem, of course, is that this isn't anything close to a normal end to the year. We are not just dealing with omicron. We are dealing with a Federal Reserve that is withdrawing liquidity and is intent on beginning rate hikes some time in the second half of the year.

Omicron is key to the bull narrative

This has caused some to shift the mix of stocks they own, but the overall effect is still very modest. Since Federal Reserve Chair Jerome Powell adopted a more aggressive stance to combat inflation around Nov. 30, defensive sectors like health care and consumer staples have outperformed, while cyclical sectors like industrials, energy and banks have slightly underperformed.

Sectors
(since Nov. 29 close)

• Health Care             up 5.1%
• Consumer Staples   up 4.2%
• S&P 500                   up 0.8%
• Industrials                down 0.7%
• Energy                     down 1.9%
• Banks                       down 3.0%

Meanwhile, technology — which is the largest sector in the S&P 500, is flat because some of the largest stocks (particularly Apple) have done well. Look past the largest names, and there is some selling, particularly in the more speculative tech stocks that Cathie Wood's ARK Innovation ETF owns.

Technology
(since Nov. 29 close)

• S&P Technology         up 0.8%
• Semiconductors         down 1.9%
• Software                      down 6.2%
• ARK Innovation        down 8.4%

Despite the uncertainty around omicron, the bull narrative has been battered but is still the dominant narrative on the Street. It goes like this: 

Omicron is highly contagious but for those fully vaccinated with a booster it is not as dangerous.

There will be no mass shutdowns of the economy.

Bottlenecks/supply chain issues will ease in the first half of 2022.

Because of this, the Fed will be less aggressive on inflation. 

The consumer remains strong.  

This combination — a strong consumer and economy, coupled with a Fed that is raising rates slowly and gradually — means the market should hold up in 2022.

A key inflation indicator is out today

The bear narrative, of course, is that omicron will lead to more persistent inflation issues. Bulls have been keeping a close eye on one of the final data points for the week — Thursday's release of the November Personal Consumption Expenditure (PCE) deflator, the Fed's preferred tool for examining inflation.

The PCE deflator gained 5.7% from the prior year, which is in line with consensus estimates from FactSet.

Core PCE, which excludes food and energy costs, came in slightly hotter than expected, rising 4.7% year over year. Consensus estimates from FactSet called for an increase of 4.6%.

"Economists expect inflation to peak here in Q4 and for the next several quarters," Marc Chandler, managing director at Bannockburn Global Forex, told me. 

"Yellen and Powell both suggested price pressures ease in H2 22," he said. "Not persistent is the new transitory."

Santa Claus rally hopes very much alive

And what about that Santa Claus rally? The ultimate hope is that the markets remain choppy in the next few days but rallies going into the close of the year.

The ultimate dream for the bulls is that we close the year at historic highs. That would not be a stretch: The old closing high of 4,712 on Dec. 10 is only 16 points away.

"That is a very small move, less than 1%," Alec Young, chief investment officer at Tactical Alpha, told me. "That is a day's trading. Even if we chop around for a few days, we can still do it."

"If you wait for the all-clear, you are going to miss the rally," he told me. "You have to weigh the probabilities, and the probabilities are we should not fear the Fed because omicron is not going to exacerbate the supply chain shortages."

The bulls' final piece of ammunition: During the month of December, the S&P 500 tends to peak during the last week or even the last day of the month, according to Jessica Rabe, co-founder of DataTrek Research.

"Since 1980, the S&P's December high happened during the last week of this month in almost half (41 pct) of years," she said in a recent note to clients.

"Bottom line: History says the S&P will likely hit another record high later this month," Rabe said.

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