Markets are in a classic 'Santa Claus' rally, but there may be a reckoning in January

Key Points
  • A trade truce, a neutral Federal Reserve, strong U.S. consumers and bottoming global growth are all good signs, but they may not be enough to move the market higher in 2020.
  • Market bulls likely will need to explain away any economic weakness on "transient" factors.
  • Following an intense bull run, a pause may be the best thing for the market.
Markets turn into a 'classic Santa Claus rally'

We are in the middle of a classic Santa Claus rally, but when the adults return in January, there likely will be a reckoning: The market has largely priced in expectations of a trade truce and a bottoming in the global economy.

The fourth quarter is proving to be a monster. The S&P 500 is up 8.8%, its strongest quarterly showing since the first quarter, when it gained 13%.

Traders have come to believe there is greater clarity on the "Four Horsemen" that have moved the markets all year: 1) A trade truce is now likely; 2) The Fed is neutral and unlikely to raise rates in 2020; 3) The U.S. consumer remains strong and the chance of a U.S. recession in 2020 are small; and 4) The global economy is showing signs of bottoming.

The issue for the market: Can it deliver on those expectations, and will that be enough?

"Expectations have moved higher on trade and global growth, and if that doesn't deliver, that's a problem," Alec Young, managing director of global markets research at FTSE Russell, said. "Bottoming may not be enough. We may need improving data."

It's not even clear we are getting a bottom. November Japanese data on retail sales and industrial production, released last Friday, was already poor. This week will see critical data that may or may not confirm the "global bottoming" theory: China manufacturing and non-manufacturing PMI on Tuesday, Euro zone PMI on Thursday and U.S. ISM manufacturing on Friday.

Even the U.S. economy, with a strong consumer, is being scrutinized. Marc Chandler, chief market strategist at Bannockburn Global Forex, is watching weekly jobless claims, out Thursday. "Claims have been elevated recently," he said. "It could be seasonal factors, but the four-week moving average is near a 12-week high. This is a close to real time indicator for the U.S. economy," he said.

One thing's for sure: The bulls are not going to give up their gains easily. Expect them to explain away any economic weakness on "transient" factors. Young believes that with prices this elevated, that strategy may not have legs. "Policymakers may look past weakness in Q4, but will investors?" he said.

Even without weaker economic data, the market is notably overbought and due for a pause. The 14-day relative strength index for the S&P 500, a momentum indicator widely watched by Wall Street technicians, is at 78, the highest level since January 2018. Any reading over 70 is overbought, readings near 80 are very overbought.

The pause would be welcome, Young noted. "The market does better with two steps up, one step back," he said. "It would be nice to get a little digestion before another leg up happens."