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In the first part of this series I established that beliefs about stock market phenomena have consequences - be they true or false. I also illustrated why predicting exactly what sort of social consequences derive from beliefs is far from a simple task.

In this article, I will explore how one might assess the potential impact on stock prices of the widespread expectation of a Santa Claus rally in 2011.

Will this widespread belief become a self fulfilling and perpetuating prophecy, or will the large consensus surrounding this phenomena actually negate its occurrence?

Whose Beliefs?

Ideas have consequences. However, ideas have consequences only in so far as they operate through particular people and in particular circumstances.

If you were to perform a survey of all stock market participants and you asked them if they believe in Santa Claus rallies, the response would probably be underwhelming. It is doubtful that one could make any predictions of stock market price fluctuations on the basis of such a survey.

However, if you segmented the survey results, you might find that beliefs about things such as Santa Claus rallies may differ very significantly amongst different classes of investors and traders.

For example, people who consider themselves "long-term investors" will probably tend to eschew the notion of Santa Claus rallies. On the other hand, amongst market participants that consider themselves to be "traders" I believe that you would find much greater receptivity to notion of Santa Claus rallies. And in particular, I believe that one would find much greater receptivity amongst "traders" to the various methods of technical analysis described in Part 1 that seem to be signaling the probability of a strong Santa Claus rally this year.

Thus, it is not just the beliefs that are important; who believes it can be even more important.

Beliefs, Actions and Price Formation

Short-term traders play a critical role in price formation - particularly when analyzing stock price fluctuations over short periods of time. Why?

In the structure of the supply and demand for equities, short-term traders are, by definition, always located at the margin of the supply and demand curves - at the place where they intersect.

Long-term investors and other types of investors that emphasize fundamental factors such as growth and/or value will by definition have a preponderant presence "deeper" within the supply and demand curve.

Thus, at any given point in time - in the absence of extraordinary factors could fundamentally alter perceptions of value deep in the layered structure of supply and demand for equities and "activate" longer term investors - short-term traders will tend to dominate the setting of prices in the market.

In this regard, it is important to note that amongst equity market participants, short-term traders (and this includes automated systems) disproportionately employ technical analysis in making decisions regarding whether to buy or sell stocks. As such, the beliefs (or algorithms) of these short-term technically inclined traders constitute a fundamental data point for the stock market forecaster.

This brings us back to the extraordinary consensus amongst technical analysts that are predicting that the S&P 500 will rally to the 1,320-1,340 area in December of 2011. As avid followers of the various systems of technical analysts, it is my belief that short-term traders are generally highly disposed to believing in a Santa Claus rally for 2011.

The Circumstances of Belief

Beliefs matter. Who believes them matters. Furthermore, the particular historical circumstances in which beliefs prevail amongst certain individuals matters a great deal.

From the generic perspective of contrarianism, the existence of an overwhelming consensus regarding a Santa Claus rally would normally be interpreted as a strong indicator that such a rally will not in fact occur.

Normally, the traders that believe in Santa Claus rallies would already be positioned for such a phenomenon ahead of the predicted event. As such, the demand from traders that usually provide the marginal sources of equity demand that tend to set short-term prices will have been largely exhausted.

Furthermore, the demand from these traders will tend to have set the price at a level that will tend to attract sellers deeper in the demand structure that are more sensitive to factors such as fundamental valuation as opposed to seasonality or momentum. In other words, at some point, upward movement in prices driven by technical traders will tend to meet resistance by fundamentally driven investors whose absolute or relative valuation objectives have been satisfied.

Thus, the relative unanimity of opinion regarding a Santa Claus rally might normally be expected to ironically conspire against its occurrence.

However, the circumstances in 2011 may not be typical. December of 2011 has been a period in which stock trading has been dominated by perceptions of critical events emanating from Europe. What short-term traders denominate as "event risk" has been extremely high on the eve of a highly anticipated EU summit on December 9th. Due to said event risks, many short-term traders may not have positioned themselves for a Santa Claus rally prior to December 9th.

Here we come upon the distinction between beliefs and action; between talking about Santa Claus rallies and actually buying stocks in anticipation of such rallies.

The divergences that occur between beliefs and actions are commonplace in human behavior. For example, studies consistently show that there has been a wild divergence between how much people say they will spend during the Christmas shopping season and what they actually spend.

Similarly, traders may talk until they are blue in the face about how great Santa Claus rallies are, but their stock positioning may not necessarily reflect that faith.

In 2011, many factors could be producing a divergence between the conviction that traders have been expressing regarding Santa Claus rallies and what they have done thus far. In this case, concerns about risks emanating from Europe could be an obvious source of divergence.

The Case For A Santa Claus Rally

Without getting into the merits of the various technical arguments in favor of a Santa Claus rally, it is entirely possible to make a strong case for its occurrence in 2011 simply on the basis of the divergence between belief and action. Many traders and investors that are otherwise well disposed to the idea of Santa Claus rallies, have held back due to the tremendous uncertainty leading up to December 9th. This situation, in turn, has given rise to a condition of pent-up demand.

Although the resolution of the December 9th summit fell far short of resolving the fundamental problems that gave rise to prior declines, it is possible that the proposals may be sufficient to temporarily placate fears of an immediate collapse in Europe.

In this context, short-term traders that may be "chomping at the bit" for a Santa Claus rally based on their TA-driven beliefs may now feel that they have the "green light" to put on that year-end trade.

Once momentum is ignited by these traders, a variety of factors could conspire to produce a powerful rally in which a trend following approach may make sense:

  • Confirmation bias. The mere fact that stocks are rising will tend to prompt traders that follow the various schools of technical analysis described above to conclude that the Santa rally that their various disciplines have been pointing towards is underway.
  • Momentum. Having recognized a discernible upward trajectory, trend-following momentum traders may jump on Santa's bandwagon (or sleigh).
  • Window dressing. Hedge funds have in general been performing poorly this year. Many may grasp at the opportunity to engage in various "window dressing" techniques designed to push stocks higher. In particular, hedge funds have been known to drive up stock prices in the illiquid conditions that exist pre-market futures and equities trading. In the midst of a general uptrend, such techniques can be effective in the short-term. Since stocks, in general, are not expensive aggressive purchases of equities that effectively push up their price can be justified on the basis of fundamentals.
  • Performance anxiety. Fund managers judged by relative returns are hyper-conscious of their performance towards the end of the year, since fund performance and compensation are generally determined on a calendar year basis. At the beginning of the year, many managers are willing to stray from the index in order to generate outperformance believing that if they make a mistake, they will still have time to make up lost ground before the end of the year. By contrast, at the end of the year, managers know that they do not have time to make up for underperformance. As such, managers become more risk averse at the end of the year - which for relative performance managers means that they will tend to "hug" the index as closely as possible. In particular, if the market starts moving, these managers in their risk-averse mode will tend to deploy all available cash very quickly and in a relatively price-insensitive manner in order to avoid losing any ground to their benchmark.

Based on the considerations laid out above, the case for a Santa Claus rally is reasonably strong. Concerns rooted in contrarianism are at least partially assuaged by the high levels of risk aversion leading up to December 9th. At the same time an alleviation of risk aversion after the conclusion of the December 9th summit will tend to release pent up demand - an ideal scenario in which to employ trend-following strategies.

The Case Against A Santa Claus Rally

There are countervailing considerations that tend to militate against the occurrence of a Santa Claus rally.

First, there is now a relatively narrow window for a Santa Claus rally to take place. Second, most of the technical analysts predicting a Santa Claus rally are also predicting a subsequent decline soon thereafter.

Both of the above factors together present a formidable obstacle to a Santa Claus rally. The reason is that traders that buy in anticipation of a Santa rally will be very mindful that they should liquidate long positions (or initiate short positions) prior to the expected subsequent decline. And since these traders are aware that other short-term traders have the same 1,320-1,340 target, many will wish to exit "early" in order to avoid the simultaneous "rush for the exits." The general perceived need to exit "early" may not allow any rally to get very far either in time or price.

Another pesky consideration should be taken into account: fundamentals. Christmas does not last forever. When Santa is gone - and perhaps even before - investors and traders will likely be forced by events to start focusing again on the very unflattering fundamental situation in Europe.

Indeed, many market participants located at different levels within the supply and demand structure for equities have been "activated" by events and are now prone to become "marginal" buyers and sellers. Their increased activity can dilute that of the Santa traders that might normally be expected to dominate the market action. Furthermore, at any moment, these investors, if activated in sufficient quantity by changing events, can overwhelm Santa traders. Indeed, even the Santa traders may be compelled to abandon Santa if the news is sufficiently important or the market action is sufficiently contrary. At that point, traders may hijack Santa's sleigh, redirect it, and ride it down to the South Pole.

Conclusion

In 2011, an extraordinary consensus seems to have to have formed regarding the prospect of a Santa Claus rally. In particular, advocates of various schools of technical analysis seem to be pointing to a powerful rally that would propel the S&P 500 (^SPX) to 1,320-1,340.

Up until now many of the investors and traders that are prone to believe in Santa Claus rallies may not actually have committed capital due to the tremendous uncertainty surrounding the December 9th EU summit. With some of that uncertainty having abated after conclusion of the summit, pent-up demand may begin to manifest in the form of aggressive biding for stocks. At that point, upward momentum can ignite a self-perpetuating process in which higher prices beget higher prices.

The danger is that a renewed focus on deteriorating fundamentals occurs at the same time that a large number of Santa traders are trying to cash in profits gained during the rally - or stopping out because the rally is aborted. At that point, stocks would tend to decline very precipitously due to aggressive selling by Santa traders and perhaps activation of longer-term investors that due to changing perceptions of value and risk go from being committed to marginal holders of equities.

Due to the incredibly high risks and stakes involved, it is my view that all but the shortest-term traders should refrain from attempting to play the equity market on the long side through individual stocks or equity market proxies such as SPDR S&P 500 ETF Trust (SPY), SPDR Dow Jones Industrial Average ETF Trust (DIA) or Powershares Nasdaq-100 Index Trust (QQQ). I believe that investors with longer time horizons should raise cash and avoid purchasing and/or holding equities - even those that appear attractive such as Apple (AAPL), Microsoft (MSFT) and Pepsi (PEP).

Read Part I of this article »

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.