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Santa rally, Version 2020

Summary:
Preface: Explaining our market timing modelsWe maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.  The Trend Asset Allocation Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”  My inner trader uses a trading model, which is a blend of price momentum

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Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
 

The Trend Asset Allocation Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
 

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts are updated weekly
 

here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

 
Santa rally, Version 2020
The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: Bullish
  • Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real-time here.
 

The Santa Claus effect

Is Santa coming to town? Historical studies have documented that seasonal strength usually starts about mid-December and continues into January.
Santa rally, Version 2020
Right on cue, the S&P 500 staged an upside breakout to a fresh all-time high last Thursday, though it pulled back Friday and the breakout held, though just barely.
Santa rally, Version 2020

How to play the Santa rally

How should traders position for seasonal strength? The most straightforward way is to stay long the equity market. Global breadth is surging, and history has shown that to be intermediate-term bullish. 
Santa rally, Version 2020

Georgia on my mind

The market could see an additional boost from the Georgia senate elections, scheduled for January 5, 2021. Currently, the Republicans hold a 50-48 seat edge, and the Democrats need to win both Georgia races to win control, as Vice-President Harris would cast the tie breaking vote in case of a deadlock.
According to Strategas, the vast majority of institutional investors expect the Republicans to retain control.
Santa rally, Version 2020
Over at the PredictIt betting markets, the market is giving a 70% chance that the Republicans will retain control. Individual odds on the Georgia senate election vary between 60-65%. In practice, they may be thought of as a single race since the voting is expected to be correlated with the other.
Santa rally, Version 2020
FiveThirtyEight’s compilation of polling averages show that the competing candidates are neck-and-neck and within a hair of each other. It wouldn’t take much of a swing for the Democrats to win both races.
Santa rally, Version 2020
A Democratic win would be interpreted as a somewhat unexpected positive surprise for the markets. Democratic control of all legislative branches of government would translate to a large stimulus bill much in the shape of the $3 trillion package passed by the House.

What’s the upside potential?

How far can a Santa Claus rally run? Marketwatch reported that technical analyst Tom DeMark has an S&P 500 target of 3907 two weeks from now.
Ask Tom DeMark how confident he is about his most recent equity-market timing call and he will imply that it is almost a no-brainer from his perspective.
“I’ve been stubborn and obstinate about 3,907 since November,” DeMark told MarketWatch in an exclusive phone interview Thursday morning.
However, he thinks that the January peak will represent the high for the first half of 2021.

But there is a catch to that late-year equity surge. The technical analyst says that it is likely to represent a top for stocks and estimates that the S&P 500 in the first half of 2021 is likely to decline by 5% to 11%, based on his models and the natural tendencies of assets in a downtrend.

A point and figure chart of the hourly S&P 500 indicates an upside objective of 3939. DeMark’s 3907 target is certainly within that ballpark.
Santa rally, Version 2020

Outperforming the rally

Having established that the odds favor a Santa Claus rally, the issue of outperforming the rally is a little bit trickier. Here are some clues from history. I made a study of the price momentum factor during this period. There are several ways of measuring momentum, the two longest existing momentum ETFs are MTUM and PDP. I analyzed whether MTUM or PDP outperformed the S&P 500 over differing time horizons, starting from December 15. As the chart below shows, there is little or no price momentum or reversal effect 10 trading days (or approximately until year-end) and 15 trading days (first week of January) after December 15. However, momentum begins to assert itself after the first week, and continues to beat the market until the 30 trading days (end of January).
Santa rally, Version 2020
What about small caps? The return pattern is very different than price momentum. The Russell 2000 has tended to beat the S&P 500 into year-end, but reversed itself in January.
Santa rally, Version 2020
A word of caution is in order for traders thinking about jumping on the small cap bandwagon in 2020. The Russell 2000 has doubled since the March bottom.
Santa rally, Version 2020
Analysis from SentimenTrader showed that sudden surges in the Russell 2000 off a major low have resolved themselves with a period of correction and consolidation.
Santa rally, Version 2020
Trying to beat the market during a Santa Claus rally is at best a guessing game. In the spirit of the season, the following picture epitomizes the trader’s dilemma. Is this a simple nativity scene, or a picture of two T-Rexes?
Santa rally, Version 2020
Disclosure: Long SPXL
About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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