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In the wake of Friday's stock market rally, it appears that the seasonal Santa Claus rally is well under way. Rob Hanna at Quantifiable Edges produced analysis that initiating a long position in the NASDAQ Composite as of Friday's close (until December 20) and held for eight days would have been profitable in 24 out of 26 years. Further analysis shows that a long position in the SPX initiated at the close on Friday, December 13, and held for 15 days would have been profitable 25 out of 29 years.

In addition, Bespoke produced analysis showing the typical seasonal pattern for the DJIA and, if history is any guide, the rally is just starting and should continue until the first week of 2014. In the past, the Dow has advanced roughly 2% from now until the first week of January.

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From a technical perspective, an upside potential of 2% makes sense. The chart of the SPX below shows upside potential of roughly 1850, based on the convergence of the 2 standard deviation upper bound of the weekly Bollinger Band depicted trend line. An advance to the 1850 level represents a gain of approximately 2%.

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A pause in early 2014?

If equity prices were to rally that much that quickly, short-term oscillators would move into overbought readings and stock prices would likely pause or correct from those levels. Breadth indicators have been showing negative divergences for the last few months and they paint a picture of a rally that is running out of steam. One likely scenario is equity prices pause after the seasonally positive Santa Clause rally.

As an example of the negative divergence shown by the breadth indicators, the Net New High/New Low NYSE indicator (top panel) is showing a pattern of lower highs and lower lows while the SPX (bottom panel) continues to advance to new all-time highs. For the bullish case to hold, I would be more comfortable with this rally if the Net New High/New Low indicator were to rise above the resistance zone shown in yellow:

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Similarly, there is a negative divergence in the number of stocks above their 50 day moving average. This is a sign of deteriorating breadth and fewer and fewer stocks are driving this rally. The resistance band, shown in yellow, will be more challenging for this breadth indicator to overcome as this market advances.

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A similar pattern of deteriorating breadth can be seen in the number of stocks above their 200 day moving averages. The message from these different breadth indicators using different methodologies and look-back windows tell the same story of declining breadth.

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Equally disturbing for the bulls who hope that a Santa Claus rally can carry on until well into 2014 is the relative performance of the small cap stocks. As the chart below of the small cap RUT compared to the large cap SPX shows, small caps have been underperforming even as the market rallied. The failure of a high beta sector like small cap stocks to assume market leadership is a knock against the longevity of this bull move.

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The performance of the mid-cap stocks is also confirmation of the relative weakness of small caps. Shouldn't higher beta stocks like mid and small cap stocks be leading the market upwards if this bull phase is to be sustainable?

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Q4 Earnings Season holds the key

I believe that Q4 Earnings Season will hold the key to the near-term direction for stock prices in January and February. Even Ed Yardeni, who had been relatively bullish, recently turned more cautious as he worried about the pace of sales momentum [emphasis added]:

Businesses are building their inventories of merchandise and new homes. That activity boosted real GDP during Q3, and may be doing it again during the current quarter. The question is whether some of this restocking is voluntary or involuntary.

The recent weakness in producer and consumer prices suggests that some of it is attributable to slower-than-expected sales. To move the merchandise, producers and distributors are offering discounts. November's surge in housing starts may also be outpacing demand, as evidenced by weak mortgage applications.

In other words, the rebound in the Citigroup Economic Surprise Index over the past 10 days might not be sustainable into the start of next year. I'm not turning pessimistic about the outlook for 2014. I am just raising a warning flag given the remarkable increase in inventories recently and weakness in pricing.

I had seen the strength in the Citigroup U.S. Economic Surprise Index as a positive, because top-line growth was lacking in Q4 Street estimates, which left share buybacks and margin expansion doing most of the heavy lifting in Q4 EPS growth (see Is a Fed taper bullish or bearish for stocks?).

The indication that we may see a near-term upside surprise in revenue growth is especially positive, because I had been concerned about the upcoming Q4 Earnings Season that begins in January. Thomson-Reuters recently deconstructed Street earnings forecasts and, as the chart below shows, consensus 4Q EPS growth depended mainly on share buybacks and "other", which is mainly margin expansion, but little or no revenue growth.

SP 500 Components of Earnings per Share Growth

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However, if the rebound in the Citigroup Economic Surprise Index is illusory, as per Yardeni, then all bets are off.

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For now, my base case scenario calls for a Santa Claus rally into the first few days of the New Year. After that, we will have to wait for signs of continued growth from Earnings Season to determine market direction. I will be closely monitoring the Manufacturing PMI reports from around the world in the first week of January for early indications of economic strength.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui's blog to ensure it is connected with Mr. Hui's obligation to deal fairly, honestly and in good faith with the blog's readers."

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Source: Welcome To The Santa Claus Rally