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Santa Claus Rally starts today. The Santa Claus Rally was discovered and named by Yale Hirsch in 1972 and published in our 1973 Stock Trader’s Almanac as the last five trading days of the year and the first two trading days of the New Year. This short, sweet rally is usually good for about 1.3% on the S&P 500, but the real significance of the SCR is as an indicator. 

It is our first seasonal indicator of the year ahead. Years when there was no Santa Claus Rally tended to precede bear markets or times when stocks hit significantly lower prices later in the year. As Yale’s famous line states (2025 Almanac page 118): “If Santa Claus Should Fail To Call, Bears May Come to Broad and Wall.” 

NASDAQ and Russell 2000 have logged the greatest frequency and magnitude of gains on the day after Christmas. Since 1988, NASDAQ has advanced 72.2% of the time with an average move of +0.38%. R2K has also advanced 72.2% of the time with an average advance of +0.40%. DJIA and S&P 500 have slightly softer records, but bullish, nonetheless. 

Two days after Christmas, the market is less bullish with NASDAQ down more often than up. Three days after Christmas R2K small caps take the lead advancing 63.9% of the time with an average gain of +0.49%. 

Fed will likely see economy at full employment

The U.S. economy added 211,000 in April as hiring rebounded following a tepid 79,000-job gain in March. The April additions were enough to bring the unemployment rate down to 4.4 percent.

While the market will celebrate the topline gain, the most important development in this report was buried in the details, which showed that those facing involuntary part time employment for economic reasons declined to 5.27 million, below the long-term average of 5.4 million. This will not be lost on policymakers at the U.S. Federal Reserve who at this point are likely moving toward a judgment call that the U.S. economy is now at or below full employment.

Meanwhile, market participants will probably interpret this data as a reason to pass the tacos and tequila later today as they celebrate the Cinco de Mayo commercial holiday in the U.S. It would be wise not to over imbibe as the central bank may soon pull away the sangria. The April estimate of employment affirmed the Fed’s recent decision to look past the slowdown in first quarter growth, and the underlying detail in the jobs report, as well as the diffusion in hiring, all point toward a 25-basis point rate increase in June, with an additional 25 basis points later this year. We have made the case that if growth, like the April jobs data, rebounds or even accelerate, the central bank may even choose to add a third 25 basis point rate increase to the two it is already forecasting.

Small Caps (Russell 2000) have often sent quality Risk On/Risk Off messages to big caps. Are small caps sending a "Risk Off" message again?

Below looks at the Russell 2000/S&P 500 Ratio over the past 5-years, highlighting that the ratio could be at an important price point.

CLICK HERE TO ENLARGE CHART ABOVE

The ratio has been moving higher since earlier this year, reflecting that small caps have been performing better than large caps. Last year the same thing happened (Small Caps stronger than Big Caps) and once the high was in and support was broken, the overall market struggled to move much higher.

Now the ratio is testing falling channel resistance at (1), near the apex of a steep rising wedge pattern.

Rising support is being tested at (2), that if broken, would send a Risk Off message to stocks.

  Stocks (^DJI, ^GSPC, ^IXIC) are rallying at midday, with the Dow Industrials soaring to new all-time highs. Energy (XLE) is leading the way, with utilities (XLU) once again in the red. Alan Valdes, director of floor operations at Silverbear, joins us to talk the market action.

To discuss the other big stories of the day, Alexis Christoforous is joined by Yahoo Finance’s Rick Newman and Melody Hahm.

Prime Day fail Amazon’s Prime Day is finally here, but customers aren’t happy. Shoppers took to social media complaining about an “add to cart fail” message each time they tried to snag a deal. Amazon says it is working to resolve the issue right away. How much trouble is this for Amazon?

Good workers are hard to find Nearly half of small businesses can’t find good workers. But the NFIB Small Business Optimism report also found that the despite the labor shortage, only a net 14% of owners indicated that they planned to hike employee pay, down from the previous month.  Should this labor shortage worry policy makers?

FDA approves prosthetic arm DARPA has funded another breakthrough. This time it’s the LUKE prosthetic arm, which can lift a bag of groceries, handle an egg and even scratch your back. How much of a game-changer is this device?

May’s hiring estimate of 38,000 new jobs likely overstated the slowing pace of employment growth in the U.S. labor market. This report strikes us as more noise than signal and we anticipate that employment growth will resume at a stronger pace, albeit one that is more in line with the six-month average of 170,000 new jobs per month than the 12-month average of 205,000 new jobs per month. For now, this report means the U.S. Federal Reserve will likely push back any plans to raise the federal funds rate before later this year, taking a summer rate increase off the table.

Once one corrects for the 35,000 striking workers at Verizon, the topline was 73,000 new jobs rather than the 38,000 which was estimated by the Bureau of Labor Statistics. Meanwhile, an unusual increase in workers who were unable to work due to bad weather points to ongoing problems in seasonal adjustments. In other words, this report deserves a giant asterisk above it and should be taken with a grain of salt.  

Moreover, the weakness of the reports stands in contrast to our proprietary survey on middle market firms, which indicates strong hiring and compensation plans in both the current quarter and in the next six months. While we believe hiring has certainly slowed, upon deeper inspection this report looks like an outlier rather than an inflection point in hiring or the economy.

The decline in the unemployment rate to 4.7 percent is a function of a 458,000 decline in the labor force which, after year-over-year growth of about 2 million new entrants into the workforce, reinforces our analysis that the May report is simply capturing statistical payback versus a turning point in the jobs market.  

Average hourly earnings increased by 0.2 percent to a year-ago change of 2.5 percent, which is in line with wage and salary increases noted in other economic reports. Wage increases are not rising at a symmetrical pace across the economy. Information workers, manufacturing workers, and those in the leisure and hospitality industries are all seeing rising wages, while those in education and healthcare are somewhat stagnant wages.  To reinforce that point, aggregate hours increased at a 0.3 percent three-month average annualized pace, which will underscore a modest improvement in spending.

We remain concerned that policy changes regarding overtime pay, increases in the minimum wage and rising healthcare costs for firms that employ more than 50 people are beginning to have an impact on the hours available to workers. The recent increase of 468,000 in involuntary unemployment, after seven months of flattening out, may in fact be a response to policy shifts and rising political risk associated with the upcoming U.S. presidential election.

Download the latest issue of The Real Economy.

2016 has been a rough year for stocks.  January was the worst start to the market ever and by mid February it looked like the world was going to end.  But the 11th marked a bottom and all indexes reversed higher.  There is still a lack of investor conviction that this leg up will stick and not turn into another rout to the downside.  

When I look at the chart for the Russell 2000 ETF ($IWM) I see many reasons to get happy about the prospects of more upside though.  There are at least 4 such indications in the chart below, in addition to the obvious short term uptrend.  First is the harmonic Shark pattern.  This carries two Potential Reversal Zones (PRZ), the first at 112.88 and and second at 118.19.  This is where the pattern would look for a reversal.

The second is the Bollinger Bands® that are opening to the upside as price is riding the envelope higher.  Momentum is one the side of higher prices too.  The MACD has been rising since mid January, but has now crossed to positive.  Finally the RSI is rising and has now moved into the bullish zone.  

The world may end and stock prices collapse, but that is not what the price action is showing right now.  

Headline inflation in the consumer price index (CPI) will jump to 2.3 percent by the end of the year, up from the current reading of 0.2 percent, as the impact of base-year dollar strength and weak energy prices fade from the data. Meanwhile, the policy-sensitive personal consumption expenditures (PCE) core inflation reading, which is what the Federal Reserve closely monitors, will increase to 1.9 from the 1.3 percent reading posted through the end of November. While inflation poses little risk to the economic outlook, a look under the hood at core data shows the risk to operating costs for the middle market.

The slowdown in the long-term potential growth rate of the U.S. economy to 1.5 percent, and wage growth in the range of 2.5 percent, both imply a narrowing of resource utilization and an upside risk to inflation during the next two to three years. If inflation moves more quickly back to the Federal Reserve’s 2 percent target, or perhaps even above it, policymakers could find themselves falling behind the curve in maintaining price stability and be forced to increase rates at a quicker pace than the market is currently expecting.

MIDDLE MARKET INSIGHT: A look under the hood at core inflation data shows rising operating costs may be a risk for the middle market.

Key to this forecast is the movement of inflation expectations this year, which, using the 10-year breakeven as the primary metric, now stand at an index reading of 1.58, up from the 2015 low of 1.3. Should inflation expectations trend higher along with the data, then our forecast should be pretty close to the mark. If inflation expectations remain low, however, then it could exert a gravitational pull lower than actual prices in the economy, thus creating the conditions where the economy will continue to undershoot the Fed’s 2 percent target measure for price stability.

Why inflation remains subdued

The U.S. trade weighted real dollar index increased 16.1 percent during the past two years while the prices of West Texas Intermediate and Brent Crude have fallen 64.3 percent and 68.4 percent, respectively. These declines have been primarily responsible low topline inflation metrics. In 2015, U.S. dollar appreciation reduced the policy sensitive PCE core measure by 0.4 percent alone. On top of that, one-time changes to administered health prices have subtracted another 0.2 percent from that measure. Those, however, are transitory factors.

Why topline inflation will jump in coming months

Meanwhile, energy dynamics inside the different inflation indexes are about to shift as the negative base effects from the collapse in energy prices over the past 18 months fade. During a three-month period from November 2014 to January 2015, the headline CPI dropped by 1.3 percent due to the sharp decline in oil and energy prices. If the topline CPI increases by 0.1 percent from December 2015 to February 2016, the core year-over-year measure should leap to 1.6 percent in January (in the data to be published in February) from the very low reading of 0.2 percent through November 2015. This adjustment in core year-over-year inflation prices is at the heart of our forecast for inflation to rise by 2.3 percent this year.

Core inflation firming

Why resource utilization matters

Inside our model of inflation, resource utilization is the primary variable that drives overall price increases. In an environment where there are only 1.4 unemployed people available for every job that is open, and an unemployment rate that is poised to drop to 4.5 percent by the end of the year, rising unit labor costs are a near certainty.

With the long-run growth rate for the economy at 1.5 percent, even a mild acceleration in wages would result in a jump in unit labor costs, thus leading to higher inflation and margin compression for firms. For small and medium enterprises, which continue to report difficulties in finding qualified individuals to fill work openings and are paying increasingly higher premiums to fill skilled, semi-skilled and public-facing positions, this may make it quite challenging to manage operating costs.

It’s all about the core

During the past several years, medical costs have been falling. But that decline has now come to an end, and both households and firms should anticipate an increase in overall medical costs. Through the midpoint of the fourth quarter of last year, medical costs in the CPI are up 3 percent (2 percent one-year earlier), medical care commodities up 2.6 percent, consumer medical care services up 3.1 percent, and consumer hospital and related services up 4.6 percent. Like the base-year effect on energy prices in the topline inflation reading, once the impact of the one-time drop in prices for Medicaid services fades from the core PCE, overall medical services in that measure should accelerate toward 2 percent, up from the 1.5 percent seen during the past six months.

Rents have also continued to climb and should do so again this year. With rental vacancies at 7.3 percent, this implies that conditions are ripe for an increase in CPI rents to above 4 percent in the near term, with additional upside risk, up from the current level of 3.3 percent.

The combination of rising labor costs, medical costs and rents should drive both the CPI and the PCE core year-over-year indexes higher to about 2 percent, right in line with the central bank’s target, by the end of the year. If so, this may shift expectations about the path of interest rates and overall central bank policy in 2017 when the first order of business for the new U.S. president and Congress will be to take a look at tax and entitlement reform. Higher inflation may complicate matters exponentially.

Read the January issue of The Real Economy

The Russell 2000 has been lagging the rest of the market since the August downturn.  it even made a lower low in September where the other indexes did not.  But there are indications now that it may play catch up.  In fact it has room to vault higher.

The chart below shows a harmonic pattern that has played out since the June top.  The fall to the August low and retrace to the September high and then a lower low.  Now the move higher and over the September high.  This targets a move to the first Potential Reversal Zone (PRZ) of a harmonic Shark at 1274.  Should it continue higher the second PRZ is at 1321.

There is support for this from other indicators.  Momentum indicators are bullish with the RSI rising and in the bull zone while the MACD is level, but positive.  The MACD may start to diverge and that is something to watch for.  The Bollinger Bands® are opening higher as it consolidates the latest leg higher.  And the Measured Move from the September bottom to the mid October plateau projected higher would give a target of 1240.