Weekly Review 18-22.12.2017.

Guide to Last 2 Weeks of the Year

There are only two weeks left until the end of 2017 and there are two main topics that will determine the market’s behavior over this short and critical timeframe. The first focal point for the market is seasonality and portfolio restructuring in advance of the end of the year. The second focal point is Republicans’ tax reform and the market’s response the moment the final details are crystalized and the bill is passed into law.

One of the places worth training your sights on is the Russell 2000 (ETF: IWM). Usually, small stocks tend to outperform the S&P 500 over the last 2 weeks of the year. In effect, statistics show that going back to 1988 if you had bought into the IWM on quadruple witching day (the third Friday of December) – only to sell 9 days later – you would have come out on top on 24 out of 30 instances.

There are a number of reasons that small-cap stocks have outperformed in the last stretch of the year. Firstly, the “January Effect!” This phenomenon describes the tendency of stocks sold because of tax considerations to see a follow-up resurgence. All-in-all, market players looking to decrease their tax obligations will free themselves of their losing stocks toward the end of the year. These stocks are usually already beaten down and will soar the moment bargain hunters discern and act on a good entry point.

The second reason that small-cap stocks tend to function better in this period, is intrinsically connected to the first reason. Market players anticipate the “January Effect” and are more and more primed to buy into speculative positions. Trading revolving the holiday season tends to be positive because, in essence, what we see playing out is a self-fulfilling prophecy! A “Santa Claus Rally,” the market’s tendency to climb in trading between Christmas and New Years takes on ever more aggressive proportions.

Even though there’s a clear tendency towards positive seasonality over the coming weeks, there’s also an implanted risk of higher volatility levels. It’s not a rarity to see a number of days of sharp selling, money managers executing their end of the year moves. Take for example last year! The S&P 500 left us with a sour feeling in our mouth with 3 consecutive losing days and aggregate losses of 1.2%. If you’re trying to capitalize on the end-of-the-year seasonality, apparently the best way to accomplish that would be to seek out individual stocks with a favorable technical pattern.

As noted above, the second item the market is grappling with is tax reform. The U.S. Congress is likely to gift American firms a holiday present, a sweeping tax cut, in other words, an injection of high-fuel octane into the stock market’s end of the year rally. The Republicans are desperate and are ready to do anything to present U.S. citizens with the reform – signed and sealed – come the end of the year. The most important topic for traders is whether the final tax reform iteration will lead to movement the likes of “selling the news.” The tax reform was one of the main developments investors had looked forward to ever since Trump’s surprise victory and the moment it pushes through, critiques about the reform will take center stage, its flaws and defects becoming the new main topic on market players’ agenda. Tax reform has been a positive catalyst each and every time the market corrected slightly and we’re now on the verge of losing the driver that had pushed the market forward on so many occasions this year. After tax reform passes, what will be the next big catalyst?! It could be the infrastructure bill – but that would lack the magical tax of tax reform!

Have a great trading week!