Even The Bears Expect A Market Rally

What was once supposed to be a year-end Santa rally has turned into the second-worst December on record for stocks. In fact, the plunge in stocks has been so dramatic it has taken even the bears by surprise, and as a result even some of the biggest skeptics are calling for a rebound.

Take BMO's Russ Visch: the technical analyst had correctly been calling for a drop into year end, and yet in his latest note writes that the widespread and price indescriminate hedge fund liquidations may have taken things too far. As Visch explains, historically December is not only the strongest month of the year for the S&P 500 but also the most consistently positive, which has created some confusion around the “Santa Claus rally” phenomenon.

As he further notes, while people assume that stocks should go straight up throughout the month from start to finish, in fact, the first half of the month is typically flat at best with most of the gains coming in the last two weeks. And after the sharp plunge in the first half of the month, Visch is now expecting something similar to develop again this year as daily breadth and momentum gauges are now oversold enough to support a solid bounce into the end of the year.

To give readers an idea of how ugly the latest data has been, the BMO strategist points out that short-term breadth oscillators are actually more oversold now than at any point since early 2016.

That said, in terms of upside potential Visch is not looking for anything more than a partial retracement of the recent decline. Some targets: the First resistance for the S&P 500 is the breakdown level at 2630, then its 50-day moving average at 2715.

But before he is accused of turning bullish, Visch makes it clear that "this is a countertrend bounce within a bigger downtrend"  as "stresses in the bond market continue to get worse, bullish sentiment continues to contract and overall breadth remains terrible."

As such, until we see heavily negative capitulative type data, he urges investors to stay defensive.

Separately, Nomura quant Masanari Takada voices similar sentiment, and looking ahead at today's main events writes that if the FOMC announcement is surprisingly more dovish than expected, speculative investors are likely to try to rebuild long equity positions on the basis that US long-term interest rates are expected to be subdued (which would be favourable to the equity market in general). However, here there is the catch 22 that we discussed yesterday: the fact that the Street’s anxiety over a possible US economic slowdown would be “officially” confirmed by the Fed would be a psychological burden, and Nomura would therefore expect most hedge funds to prefer to tilt towards defensive sectors or low-volatility names over cyclical sectors or high-beta names.

Nomura's lukewarm conclusion: "given the limited capacity of HFs overall to take on equity risk at the moment, a feasible equity market rally driven by a dovish Fed would likely only last a relatively short period of time."