Week Ahead: Thin Holiday Trading Could Bring Santa Rally For Stocks But Risks Loom

After investors responded positively to the Federal Reserve's tightening agenda, as markets head into the final weeks of trading in 2021 one would have expected volatility to steady or sink. However, with Omicron a continued risk, it shouldn't have been surprising for investors to manifest a delayed reaction to the US central bank's more hawkish monetary policy.

After Wednesday's post-FOMC meeting rally, when stocks surprised by rising, analysts posited that the decision to speed up bond-purchasing and hike rates three times in 2022 was already baked in for investors. However, on Thursday sentiment reversed and tech shares led the stock selloff.

Belated Reaction Or Longer Ranging Worries?

Could it be that suddenly it simply dawned on investors that mega cap tech company valuations would be pressured amid rising borrowing costs? Since the equity selloff extended on Friday, it clearly wasn't only because of overstretched valuations in the technology sector. Real Estate shares dropped 0.34%, Communication Services equities lost 0.4% and Technology shares continued plunging, down 0.67% on the final day of last week's trading. Only cyclical sectors lost more: Energy tumbled 2% and Financials slumped 2.2% on the day.

Friday's selloff was due primarily to the quarterly expiration of options and futures. So, perhaps the selloffs are over and stocks will now either cruise smoothly into thin, year-end holiday trading, or even provide traders with a Santa Claus rally for Christmas.

There are, however, a few worrying signals.

First, it's possible Friday's selloff was at least partly provoked by Federal Reserve Governor Christopher Waller, who said rates could rise as early as March since the US is "closing in" on maximum employment. His remarks boosted the dollar so perhaps, at the same time, the comments weighed on stocks.

There's yet another red flag: market breadth has been getting narrower.

While tech stocks have been the primary drivers for the series of record highs hit by major US indices this year, just 31% of stocks listed on the NASDAQ Composite are above their respective 200 DMAs, even as the tech benchmark is up 18% for the year. On the other hand, 36% of listed companies on the small cap Russell 2000 are trading above their respecting 200 DMAs.

The S&P 500 is showing yet more positive breadth; 68% of the index's components are trading above their respective 200 DMAs. Nevertheless, the SPX is exposed to additional volatility since just five of its listed stocks—Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), NVIDIA (NASDAQ:NVDA), Tesla (NASDAQ:TSLA), and Alphabet (NASDAQ:GOOGL)—are responsible for roughly 50% of the benchmark's rally since April.

So far, the S&P 500 is about 24% higher year-to-date and continues to hover near its record highs. Nonetheless, the greater risk remains with technology stocks listed on the NASDAQ.

Via the monthly chart, it's easy to see the strong negative divergence between the tech-heavy index's price and the Advance-Decline line going back to January 2018. As well, we could be witnessing a monthly Evening Star in the making. If the price falls to its monthly lows, it will have penetrated halfway into October's candlestick, after November's candle gapped up, producing a Gravestone Doji.

There are additional signs investors are shying away from risk.

During the past week, as well as through the previous month, the best-performing stocks all belonged to defensive sectors. Over the two time frames, there were only four segments in the green. On a weekly basis, Healthcare outperformed, rising 2.5%, Real Estate shares followed, up 1.75%; Consumer Staples gained 1.35% while Utilities rose 1.25%.

For December so far, Utilities rose 4.1%; Consumer Staples gained 3.6%, followed by Real Estate's 3.25% rise while Healthcare added 3.1%.

The Treasury yield curve flattened, another risk-off tell, as the spread between the 5-year and 30-year notes narrowed.

When the economy is considered healthy, investors want a higher yield for funds committed over longer timeframes. When the yield between shorter and longer duration Treasuries flattens, it suggests investors are losing faith that bond yields will reward them for tying up their money over the longer term.

When the curve inverts, with short-term issues crossing above yields of longer-term bonds, it signals that short-term borrowing costs are more expensive than longer-term loans. This yield reversal is a sign that something is wrong with the economy. It's considered to be a leading recession indicator.

Notwithstanding the various reasons for caution, the current market narrative anticipates that stocks will retain their record highs—at least over the next week and even during the week after that, amid thin trading. However volatility levels could yet escalate.

The dollar surged on Friday after Fed Governor Waller indicated that the Fed's first hike could come in March.

The greenback may be forming an ascending triangle which would complete with an upside breakout.

Gold gained on Friday, extending its rally for a second day, despite Friday's powerful dollar green candle amid the strongest rise for the USD since Nov. 10.

The yellow metal found support above the bottom of a symmetrical triangle. The direction of the breakout will likely determine the next move.

Gold's advance, even amid dollar strength, is another sign investors are increasing defensive positioning.

Bitcoin is falling for a sixth straight week, its longest weekly losing streak since December 2018.

After falling below its uptrend line since the July bottom, Bitcoin's next support is at the low $40,000s, where the September and November lows meet with the uptrend line since the October 2020 low.

Oil slumped on Friday, ending a two day rally.

We provided a bearish call on WTI this past Wednesday. However, if oil turns higher and breaks the $73 level, it will reverse a would-be bearish flag (red converging, rising lines) to a bullish flag (purple) as it breaks through its (dotted) downtrend line since the Nov. 10 high. Of course, that all likely depends on Omicron developments.

The Week Ahead

All times listed are EST

Sunday

20:30: China – PBoC Loan Prime Rate: previous fix was 3.85%.

Monday

19:30: Australia – RBA Meeting Minutes

Tuesday

4:30: UK – Retail Sales: expected to rise to 1.0% from 0.8% MoM.

8:30: Canada – Core Retail Sales: likely to surge to 1.6% from -0.2%.

18:50: Japan – BoJ Monetary Policy Statement

Wednesday

2:00: UK – GDP: seen to remain flat at 1.3% for the quarter and 6.6% YoY.

8:30: US – GDP predicted to remain unchanged at 2.1% QoQ.

10:00: US – CB Consumer Confidence: forecast to edge up to 110.2 from 109.5.

10:00: US – Existing Home Sales: anticipated to rise to 6.50M from 6.34M.

10:30: US – Crude Oil Inventories: likely to jump to -2.082M from -4.58M.

Thursday

8:30: US – Core Durable Goods Orders: presumed to edge higher to 0.6% from 0.5%.

8:30: US – Initial Jobless Claims: expected to shrink to 205K from 206K.

8:30: Canada – GDP: predicted to retreat to 0.8% from 0.1% MoM.

10:00: US – New Home Sales: foreseen to have jumped to 770K from 745K.

Friday

Array of global markets will be closed ahead of the Christmas Holiday