Will Santa Rally fly into fiscal cliff or be grounded by Italy or recession in Japan and Europe?

As Christmas carols fill the air and shoppers head for the malls, it’s that time of year when everyone starts talking about the possibility of a “Santa Rally”.  Will stock prices run up as the year ends – with people investing their bonuses and driving up profits for retailers, or will the Grinch steal Christmas as Congress and the White House battle over the fiscal cliff.  If the Grinch has his way, Santa’s sleigh will fly right into the fiscal cliff.  Read “Small Cap Strength Starts Mid December”

The S&P 500 and related ETFs started a recovery from their October swoon a couple of weeks ago and spent most of last week in a slow climb, as commentators gnashed their teeth over the consequences of a budget battle impasse by year’s end.  At market close on Friday, the S&P (NYSEARCA:SPY) managed to finish the session at 1,418, closing above its 50-day moving average for the first time since October 19.

A look at the S&P 500 (NYSEARCA:SPY) chart shows us an inverse head-and-shoulders pattern, which we have been following since November 23 (see green bar on chart) suggesting the possibility of a further advance.  Since that time, a larger inverse head-and-shoulders pattern has developed (indicated by the blue bar), with the old head resembling a Santa Claus hat atop the new head.  This is obviously a good omen for the possibility of an upcoming Santa Rally.

 chart courtesy of StockCharts.com

Despite the popular use of the term “fiscal cliff” and its risk to the Santa Rally, the situation actually refers to a gradual phasing-in of tax hikes and spending cuts.  Nevertheless, from the investors’ standpoint, if we reach a point when “sequestration” becomes inevitable, the impact on stock prices could be quite abrupt.  If fiscal cliff fears spook shoppers during the holiday season, the short-term impact to stock prices could be nearly as bad and this year’s Santa Rally could be cancelled by the Grinch. Read “Fiscal Cliff Countdown Continues With No Progress In Sight”

Other problems facing the Santa Rally this year include the recently announced recession in Japan as the country has now logged two consecutive quarters of declining GDP.  Nissan and Honda reduced forecasts for yearly profits due to slow global sales, particularly in China, and the Japanese economy hit recessionary levels in the second and third quarters, with an annualized decline in GDP of 3.5% in Q3.  The first quarter posted a 0.1% decline and so the back to back contractions qualify as a recession.

In Europe, the developing situation in Italy could also threaten the Santa Rally as  Italy’s Prime Minister, Mario Monti, announced his resignation and Silvio Berlusconi,  the former leader, announced that he was going to run again on an anti-Monti, anit-austerity platform.  This is potentially bad news for Italy and Europe as bond yields spiked and Europe continues struggling with its debt crisis. Read Euro ETFs Decline

Regarding the Santa Rally itself, Jeffery Hirsch points out on page 110 of his Stock Trader’s Almanac 2013, investors tend to get rid of their stock losers near year-end for tax purposes, often hammering these stocks down to bargain levels. Studies have revealed that – rather than a “Santa Claus rally”, stocks usually rally during the final days of the year, including the period after Christmas.  This is referred to as the “turn of the year” effect.

Jeff Hirsch also points out The Santa Rally is the last five trading days of the year and the first two trading days of the New Year, and that it’s generally a bullish time of the year.  Year end selling is over and the period generally sees an average gain of about 1-1/2% on the S&P 500 during that week.

But Jeff goes on to say that the real significance of the Santa Rally is when that period of time does not show a gain for the S&P, (NYSEARCA:SPY) it has been a harbinger of lower prices. That happened in 2000 and 2008, which were down years and in 1994 and 1995 which were flat years. Yale Hirsch, founder of Stock Trader’s Almanac coined a famous slogan in this regard, “If Santa should fail to call, bears may come to Broad and Wall.”

So as we wait to see if Santa will arrive or not, many commentators have listed bonds at the top of their Christmas wish lists, ahead of stocks.  As a result, the iShares Barclays 7-10 Year Treasury Bond Fund ETF (NYSEARCA:IEF) could turn out to be the 2012 “stocking stuffer of the year”.  Here is a list of some other government bond ETFs which you may want to consider if you are worried that the Fiscal Cliff Grinch will steal the Santa Claus rally this year:

iShares Barclays 1-3 Year Treasury Bond Fund (NYSEARCA:SHY)

iShares Barclays 10-20 Year Treasury Bond Fund (NYSEARCA:TLH)

Schwab Intermediate-Term U.S. Treasury ETF (SCHR)

SPDR Barclays Capital Intermediate Term Treasury ETF (NYSEARCA:ITE)

Bottom line: So no one knows if the Santa Rally will appear or if Santa’s sleigh will fly over the fiscal cliff if political leaders cannot come to a settlement by December 31st.  However, with the clock ticking towards the fiscal cliff and Christmas, this Holiday Season promises to be unusually exciting, indeed.

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About John Nyaradi (http://www.wallstreetsectorselector.com) John Nyaradi is Publisher of Wall Street Sector Selector: Your Home For ETF Investing! John writes a weekly guest column, John Nyaradi’s ETF Edge for MarketWatch.com and his investment articles have appeared in many online publications including Trading Markets, Money Show, Yahoo Finance, Investors Insight, Fidelity, ETF Daily News, iStock Analyst , among many others. His book, Super Sectors: How to Outsmart the Market Using Sector Rotation and ETFs, is published by John Wiley and Sons and included among the Years Top Investment Books in the 2011 Stock Trader’s Almanac.