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The buzz surrounding a possible Santa Claus rally this year has been stronger than I can ever remember. I have been particularly struck by the fact that a large and very vocal majority of technical analysts - even among those specializing in radically different sub-disciplines - are predicting a sharp year-end rally with virtually identical targets: S&P 1,320-1,340.

In light of the current market environment what does this remarkable convergence of technical opinion portend? Should we believe in the much-anticipated Santa Claus rally, or not?

Trend Following, Contrarianism and Pattern Repetition

In assessing the probabilities of a Santa Claus rally, I believe that it will be instructive to first review some basic principles of technical analysis.

There are many theories of technical analysis which claim that stock prices can be predicted systematically, albeit only probabilistically. Despite their different approaches, virtually all schools of technical analysis share in common a quest to interpret and apply at least three basic principles:

  • Trend following: Technical analysis attempts to identify a trend relatively early within an identifiable pattern in order to exploit it. "The trend is your friend," is an oft-repeated aphorism amongst technical analysts. Trend following is based on the principle of momentum: It is posited that once market prices get moving in a particular direction, they tend to continue to move in that direction. It has been hypothesized that this tendency derives from a general human proclivity towards "herding" or trend-following behavior. It may also derive from lags in the efficient dissemination and processing of relevant information in the market place - i.e. some investors obtain information faster and/or process it more efficiently than others.
  • Contrarianism. Another well-known tenet of virtually all systems of technical analysis posits investors should do the opposite of what the "herd" is doing. According to this theory, investors should buy when the herd is selling and sell when the herd is buying. The reasoning behind this thesis is two-fold. First, virtually all schools of technical analysis assert that stock prices exhibit cyclical tendencies, such as mean reversion. To the extent that this is true, an investor will presumably profit by identifying when herding behavior has led to an extreme limit within an identified cycle and bet on prices moving in the opposite direction. Second, it is argued that contrarianism works because of the role of widely held expectations in asset pricing. If the "herd" has an expectation that prices will move in a certain direction, those widespread expectations of movement in that direction will have already been "priced in" or "reflected" in current prices. Such convergent expectations naturally tend to produce or perhaps even define extremes in prices, setting up a subsequent move in the opposite direction.
  • Pattern recognition. Many technical analysts believe that human behavior, reflected in market prices, tend to follow predictable patterns. The different schools of technical analysis differentiate themselves largely on the basis of the specific kinds of patterns they claim contain predictive information. Examples of such patterns would be, "head and shoulders," "Presidential Cycles," "Santa Claus rallies," "Elliot Waves," "Gann Square of 9" and "TD sequential countdowns." The basic premise is that if an analyst can properly identify where prices are located with regards to one of these patterns (in price and/or time) that the analyst can predict the subsequent direction of market prices with reasonable probability.

It is important to note that ideally, the principles of pattern recognition, momentum and contrarianism can be harmonized and be made to work together. For example, technical analysis posits that an analyst can identify points in an early stage of a movement within a recognizable pattern in which it is advisable to "follow the trend." Similarly, a technical analyst may also be able to recognize a turning point or pivot in the pattern where it is advisable to position oneself in a "contrarian" fashion, or against the previously prevailing trend.

The challenge for the analyst is that these three basic principles of technical analysis often come into conflict - or at least appear to contradict. Speculation surrounding this year's potential "Santa Claus rally," is an interesting case to analyze in this regard.

What Technical Analysts Are Saying

What makes the case of the 2011 "Santa Claus rally" very interesting is that analysts from different sub-specialties of technical analysis seem to coincide regarding the likelihood that there will be a powerful occurrence of this phenomenon this year. Despite the fact that these analysts all look at different kinds of patterns, there is an extraordinary coincidence of opinion that points to a target of 1,320-1,340 on the S&P 500.

  • Elliot Wave. Avi Gilburt has been predicting a Santa Claus rally for some time now based on an "Elliot Wave count," that he claims is especially buttressed by strong "Fibonacci" patterns within that particular wave structure. His target is 1,320-1,340 on the S&P 500.
  • DeMark. Tom DeMark, the founder of the increasingly popular TD system, is predicting a Santa Claus rally to the 1,320-1,340 level based on a characteristic sequence of prices.
  • Gann. Jeff Cooper, perhaps the best-known practitioner of the forecasting methods of W.D. Gann, has argued that various convergences of date cycles and price pivots point to a rally towards the 1,320 to 1,340 level.
  • Conventional TA. Numerous practitioners of "conventional" technical analysis have identified various basic "trend lines" as well as conventional "horizontal support and resistance levels" that seem to project a move towards the 1,320 to 1,340 level.

I do not wish to join the debate regarding which, if any, of these methods and/or analysts is most reliable. For the purpose of the present article, what I find most interesting is that they all seem to coincide regarding direction, timing and price target. Such a general consensus amongst technical analysts from different sub-disciplines is a relatively relatively rare occurrence.

Thus, the question is: Should this extraordinary consensus be taken as a coincident or contrary indicator?

Do You Believe In Santa Claus? Should You?

For purposes of this article, readers should assume that I am entirely agnostic regarding the merits of various schools of technical analysis - I neither believe in them nor disbelieve in them.

So why mention them at all?

Because beliefs matter. Or as philosopher Richard Weaver might have said: Ideas have consequences. True or false, good or bad, beliefs affect human behavior. In particular, beliefs condition behavior by affecting the value that human beings assign to things.

Let me give you an example. I do not believe in the vast majority of claims associated with the notion of stock market seasonality - including the notion of "Santa Claus rallies." Most of the "research" that purportedly supports seasonal stock market patterns is about as empirically and theoretically sound as the research that upholds the "Super Bowl indicator." Indeed, the sort of analysis that posits these phenomena typically constitute a textbook example of "data mining" of the worst kind - a kind that does not even possess a minimum threshold of statistical credibility given the pitifully low sample sizes involved in the data sets involved.

However, the fact that the theoretical and empirical bases for Santa Claus rallies are bogus does not mean that this notion must be irrelevant for stock market forecasting at any given time. In some contexts, popular beliefs - even erroneous beliefs - regarding such phenomena could prove to be highly relevant.

Let us explore an example from another field to illustrate how false beliefs can become highly relevant to the prognostication of human behavior in certain contexts. I don't believe that extra-terrestrial beings frequently visit the earth via spaceships. I believe there is overwhelming evidence that such ET phenomena do not exist. However, if on the basis of this evidence I were to make a wager predicting that nobody will be attending UFO conference in Phoenix, Arizona on February 22-26 of this year or a similar one in Eureka Springs, Arkansas from April 13-15, I would be quite foolish. People will be going to those conferences. Lots of them. In this particular context of behavioral forecasting, it is far less important to understand what is true than it is to understand what people believe is true.

So lets get back to Santa Claus rallies. Whether Santa Claus rallies exist as a legitimate phenomenon or what causes them may not be determinative to whether a large rally occurs in December of 2011. It may be more important to understand what people believe about Santa Claus rallies in 2011.

As we have seen in the case of prediction UFO convention attendance, the mere fact that people believe certain things - even if those things are false - is a data point that must be taken into account in predicting human behavior.

There is yet another consideration in regards to belief: Keynes' beauty contest insight. Stock market almanacs are a testament to the fact that many people believe it is important that many other people believe in things such as Santa Claus rallies. Thus, belief about belief constitutes an additional critical data point for purposes of behavioral prediction.

Conclusion

As we have seen, a great number of people believe that there will be a Santa Claus rally in 2011 due to technical considerations. A substantial number of additional people believe that other people believe this. These beliefs, in and of themselves, are important data points.

However, discerning the impact of these beliefs on the stock prices of Apple (NASDAQ:AAPL) or Microsoft (NASDAQ:MSFT) or of entire indices represented by stocks such as SPDR S&P 500 ETF Trust (SPY), SPDR Dow Jones Industrial Average ETF Trust (DIA) or Powershares Nasdaq-100 Index Trust (QQQ) is not a simple matter. There is a complex and seemingly paradoxical relationship between the dispersion and intensity of beliefs and the impact of those beliefs on social behavior as reflected in stock prices.

As we shall see in Part II, the widespread belief in a Santa Claus rally could become a fundamental driver of one actually occurring. Or quite the opposite might be the case: Widespread belief in a Santa Claus rally could be a fundamental factor that prevents it from occurring.

What should we believe?

Read Part II of this article »

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

Source: Santa Claus Rally Prospects, Part I