Why a Santa Claus rally might not be in the cards

Many traders expect stocks to rally into the year-end, but the current complacency may be signaling that a late year Santa rally is not in the cards.

If the S&P 500 closes higher Tuesday, it will be the 43rd record high of the year. Stocks traded quietly on low volume Monday, with the Dow up just 13 points at 17,647 and the S&P 500 up 1 point at a record 2,041. The Nasdaq fell 17 points to 4,671, and the Russell 2000 was the worst performer—own 0.8 percent to 1,164.

"We're a little concerned by the fact that investors' memories have become so short that volatility has just completely collapsed to multiyear lows a month away from an incredibly frightening roller-coaster ride. The bearish readings have slipped," said Julian Emanuel, equity strategist at UBS. "A lot of people expect the year to end on a high note."

Traders on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters
Traders on the floor of the New York Stock Exchange.

Emanuel said he had expected a rally into year-end but the market's recent behavior is making him more cautious. "I personally have never seen volatility get crunched like this so early before Thanksgiving. It usually happens at the end of December or in August," he said.

Emanuel said he watches the 10-day realized volatility for the S&P 500, a reading of the close to close changes in the S&P over a 10-day period. It was at 3.38 Monday. "It's extraordinary. The 200-day moving average is 10.8," he said. "The range over the last two weeks have been the lowest they've been in aggregate in over five years."

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According to Emanuel, the reading may not be signaling a selloff but rather just limited gains.

"The market to us just feels like upside, rather than a setback. It feels like the upside is capped because you have this combination of low volatility and very complacent sentiment, and Japan tells you the problems are still out there," he said.

Stocks were boosted by big merger deals Monday but also held in check by the surprise news that Japan has fallen into recession, he said. Allergan is being acquired by Actavis for $66 billion, and Baker Hughes reached a $35 billion merger deal with Halliburton.

"If you look at the M&A announcements, it's very healthy. If you look at the activity in the healthcare sector, that sector has the most cash along with technology and they are going to be spending it," he said.

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More energy deals are also expected as oil prices continue to weaken. West Texas Intermediate crude closed at $75.64 per barrel Monday, off 18 cents. Natural gas, meanwhile, jumped 8 percent on cold weather to $4.34 per million BTUs.

What to watch

The producer price index is reported at 8:30 a.m. EST and is expected to show a 0.1 percent decline, but a gain of 0.1 percent when food and energy are excluded. TIC data, or international capital flows, is expected at 9 a.m. and home builder sentiment is at 10 a.m.

Earnings are expected from Home Depot, Dick's Sporting Goods, TJX, Medtronic and JA Solar before the open. PetSmart, Jack in the Box and La-Z-Boy report after the close.