- The typical Santa Claus rally in stocks is threatened this year as bearish fundamentals dominate, according to TS Lombard.
- The investment firm said the equity rally since the mid-October low "looks overdone."
- The threat of a recession implies higher volatility going forward, which is a negative for stock prices.
Investors have been conditioned to expect a Santa Claus rally in the stock market heading into year-end as trading volumes decline, news flows dwindle, and positive psychology permeates among retail investors, but that may not be the case this year.
According to a note from TS Lombard, while positive seasonals definitely boost the prospect of further gains, they're outweighed by the fundamentals.
And right now, three bearish fundamental factors are dominating the markets and increase the likelihood that the typical Santa Claus rally stumbles this year, according to the note.
"Equity performance looks overdone."
Stocks have already seen big gains since their mid-October low, with the S&P 500 rallying 13%, and up 10% so far in the fourth quarter. But those gains are double the median fourth-quarter rally of 5.5%, and the average fourth-quarter rally of 4.3%.
"Additionally, when the S&P rallies above its 50 and 100-day moving average, it looks technically vulnerable as it heads towards its 200-day moving average," TS Lombard said. That's exactly what's happening, as the index backed away from its 200-day moving average in recent days, falling more than 2%.
"Moreover, the rally in equities contrasts with the rates volatility rebound on the recent spate of Fed hawkish speak," TS Lombard said. The 10-year US Treasury yield has surged nearly 20 basis points over the past two days to 3.77%.
"There is a lot of event risk into yearend."
"This week alone we will have a key speech from Powell, US core PCE and a jobs report, followed by an OPEC meeting at the weekend. Then virtually every developed market central bank will report over a two-week period. Plus there will be the US CPI one day before the final Fed meeting of the year, where we will get a new set of projections, dots, and the markets pivot narrative will be put to the test," TS Lombard said.
That's a lot of volatile events for investors to digest in such a short period of time, and it could ultimately lead to big downside moves in the stock market.
"Recession generally implies lower risk assets and higher volatility."
As yield curves turn inverted, the writing is on the wall: an economic recession is imminent. That's been TS Lombard's base case since the summer, and the effects of a economy slow walking into a recession means investor sentiment is likely to plummet.
"It is important to note that as the economy deteriorates into a recession, adverse sentiment kicks in and things tend to become non-linear, accelerating the slowdown. Correspondingly, volatility tends to rise form half a year before the recession begins, spiking at the start of the recession," TS Lombard said.
Altogether, the heightened risk for the economy and volatility means that while the end of the year tends to be positive for the stock market based on seasonals, there's high likelihood that bearish fundamentals could dominate and lead to a fizzled out rally.