Tug of War

 | Dec 27, 2011 | 4:30 PM EST
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It's that time of the year when Santa comes to town and the market generally trades higher. It's known as the Santa Claus rally, and it occurs during the last five trading sessions of December and the first two sessions of January. So, in early December, when someone says that the market is moving higher because of the Santa Claus rally, they are in need of a calendar and/or some facts. It's not a generalized feel-good rally that can occur at any point around the end of the year; it's tied to the calendar. This time around, the pattern began last Friday, and it ends next Wednesday.

The average gain over the past 60 years has been about 1.5% over the seven-session period. That's the good (bullish) news. The bad (bearish) news is that the S&P 500 has already gained over 15 points from last Thursday's close to this morning's highs, which is already more than 1%. In fact, the average gain of 1.5% occurs at 1272.81. Not far from this morning's high of 1269.37.

In case you're wondering, last year the S&P 500 gained 1.07% over that seven-session stretch. Not surprisingly, the index was trading near current levels last year at this time and began the Santa Claus rally from the close of Dec. 23 at 1256.77. This year, the pattern began at last Thursday's close (Dec. 22), with the S&P 500 just a few points lower at 1254.00. The target for the move is 1273, not far above today's highs. Not to say that it can't go higher, but, again, it looks like the easy money has been made.

Arguing for some kind of top in that same area around 1273 is the gap from Nov. 9, which gets filled at 1275.91 in the cash. The equivalent gap in the futures (on the continuation charts) points somewhat higher as that gap occurs at 1273.20 or roughly 1279 in the cash. Either way, some kind of stalling is likely in that area.

S&P 500: Heading for 1273-1276
Source: optionsXpress

Of course, it's never about just one thing. There are, as usual, other factors to consider. The Russell 2000 also has some nearby targets. It's that Nov, 9 gap that has been frustrating the index for weeks now.

Back on Dec. 5, the Russell 2000 popped up to the 752.71 level, less than 3 points shy of its Nov. 9 gap at 755.27. From there, it collapsed 47 points, a drop of more than 6%, all the way back down to the 705.47 level. And now, a few weeks later, here we are again, knocking on the door of that gap.

Today's high so far has been 751.71, just a point shy of the early-December high. A move above 753 is likely headed to the top of that gap. A move above the 755.27 level should point still higher, but I won't be betting on that. Instead, I look for some further stalling once that gap is filled.

If it weren't for Santa, I'd be unloading my remaining positions in the Russell 2000 at the top of that gap. But given the seasonal strength, I am inclined to maintain moderate exposure for a bit longer. Still up to 40% long equities, or as much as 50%, if you include the other stuff such as junk bond holdings.

Russell 2000: Working on Its Nov. 9 Gap
Source: optionsXpress

If the move higher continues into early next week, however, and if the market becomes even more overbought, then I will likely be cutting back positions again by the middle of next week at the latest. The McClellan Oscillator is now, once again, becoming quite overbought, settling on Friday at +148. That's pretty extended, though it's got room to get even more stretched during this time frame. Basically, it's a tug of war between the strong seasonal pattern pointing higher and the overbought market suggesting it's time for a breather.

The sentiment picture remains problematic as evidenced by the collapse in the CBOE Volatility Index (VIX) to even lower lows. People who think that the real problem is Europe or the eurozone are simply deluded. They continue to chase yesterday's news. The issue is ahead of us, and that's what is reflected in the VIX.

VIX: New Lows = Too Many Bullish Bets
Source: optionsXpress

Color me cautiously optimistic, but becoming more cautious and less optimistic as the beginning of 2012 approaches, especially as the market becomes increasingly overbought.

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