Embrace the selloff

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Getty Images

After weeks of marching higher, a bout of stock market selling at the start of what is normally a robust month for stocks has some investors on edge.

Traders are questioning the lack of buying at the start of the month, which is usually a time when new money floods the market, driving stocks higher. The last time a month started off negatively for the Dow and S&P 500 was May, a positive month for the market but the beginning of a rout that ended in June. May was also a month that saw interest rates lift off the year’s lows on talk that the Fed could slow down its quantitative easing program.

But December has something going for it that June does not have. The strong seasonality associated with the year-end has many strategists believing in a Santa rally, with visions of big investors swooping in at the last minute to put the finishing touch on year-end returns.

“I think we get a Santa rally. This is the most denied bull market ever. But I think people are going to come around with window dressing and the more natural process of people returning to a normal exposure to equities,” said John Stoltzfus, Oppenheimer Asset Management’s chief market strategist. “We think we will get a Santa rally, while it may not be one with very loud jingle bells, it should be one of good cheer.”

(Read moreWith jobs data on horizon, expect some selling)

The Grinch, however, could again be higher bond yields, which traders say could steal some stock market gains if interest rates rise too quickly. Stocks on Tuesday slumped, amid signs that investors are rotating holdings, putting both cyclicals and defensive names in the winners and losers categories. The defensive utility and consumer staples sectors, followed by energy and tech were the best performers, while consumer discretionary and the defensive health-care sector were losers.

The stock market hiccup also comes as traders look ahead to the end of the week, when Friday’s November jobs report could provide major clues as to the course of monetary policy. If nonfarm payrolls are close to last month’s 204,000 payrolls, or higher, traders expect to see a period of volatility up to the Dec. 17 and 18 Fed meeting, where it will decide whether to taper back its bond-buying program.

“I think it’s healthy. Everybody is so eager to see a little bit of steam let off here that when they look at a market down 0.34 percent on the industrials, it’s ‘wow, we’ve got a pullback’ but it’s not really,” said Stoltzfus. “From my perspective, I’ll settle with moving sideways with a slightly negative bias. I do think market participants have a real desire to see some kind of catalyst that would bring this market down 4 to 6 percent. I would be careful what you wish for.”

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Stronger data, like Monday’s November ISM manufacturing report, gave a boost to speculation that the Fed could decide to taper its bond purchases at its December meeting, though most Fed watchers believe it will wait until January or March.

Stocks were also on edge Tuesday due to the move higher in interest rates, which traders say will sting stocks if they move too rapidly or edge closer to 3 percent on the 10-year note. The stock market could also put the brakes on a bond selloff, as bond buyers would be drawn in from any major shakeout in stocks. At the same time, buyers that are waiting for dips to buy stocks have been frustrated by the lack of a major selloff. The S&P is up 26 percent year-to-date.

“It’s had to do with the Fed all year. Fed largesse suppressing interest rates,” said Peter Boockvar, chief market analyst at the Lindsey Group. “Now the Fed hasn’t tapered one dollar. … Why yesterday, 2.80 (10-year yield) was the trigger for stocks, I don’t know, but it was. We’re seeing before our eyes the bond market is tapering for the Fed again.”

(Read more: Gross: Fed will keep rates low until at least 2016)

Stocks suffered mild losses Monday and as of midday Tuesday, the small-cap Russell 2000 led the declines, losing more than 1.6 percent for the week so far, while the Dow was down more than 1 percent, and the Nasdaq and S&P 500 were down about a half percent. The VIX, however, was up more than 3 percent, edging close to 15. The VIX is the CBOE’s volatility index, and reflects how investors are hedging in the options market. A low VIX indicates complacency, and the VIX has not been at this level since October.

December is historically the best month on average for the Dow, and it is the second-best month of the year on average for the S&P 500. In the last 10 years, the S&P was positive 80 percent of the time while the Dow was positive 70 percent. Both the Dow and S&P have been higher for eight weeks in a row.

Stoltzfus said there is some evidence of tax-related selling in stocks against losses in bonds, though BMO Private Bank CIO Jack Ablin believes that selling will be tempered as many investors are not eager to trigger capital gains after the market’s big run this year.

“The only reason you would sell now is if you’re trying to do some performance window dressing. But even then you wouldn’t want to get out of the market completely,” said Ablin.

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“I don’t see any ominous signs clouding the market right now. I’m not worried yet. We’ve got a lot of momentum and a lot of liquidity, and yes things are expensive and at some point people have to worry about earnings, but they don’t have to do that until January.”

Ablin said if the Fed effectively steers the market dialogue toward its emphasis on keeping short-term rates lower for a longer period of time, the market may begin to process positive economic news as a positive for stocks, rather than a negative for quantitative easing. QE impacts the longer end of the curve, as the Fed buys longer-dated Treasurys and mortgage-backed securities.

“They pretty much left the front end alone and what they’re hoping to do is have the yield curve steepen. That creates a favorable net interest margin for banks, and then they will try to reiterate this forward guidance that says we have your back,” he said.

The stock market would then process positive economic news as a positive. “Last month’s (jobs number) was a grand slam. You had over 200,000, plus enormous revisions,” Ablin said. “All we need to do is have something that shows job creation is in line, and I think we’re fine. I think there’s worry out there that last month was an aberration.”

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For all the hand-wringing about the wind down of QE, Stoltzfus said the markets actually would favor a return to normalcy, which could also mean higher yields. He expects anticipation about Fed tapering to drive yields, and mortgage rates, high enough to give the Fed pause as it did in September, when many Fed watchers had expected the Fed to begin cutting back on its $85 billion in monthly purchases. That could keep the Fed on hold until March or later, he said.

Boockvar, however, said markets are already reacting to higher rates. “The FTSE is the poster boy for squishy stock trading from better data because of the prospect of higher interest rates and the Bank of England shifting policy in 2014,” he said, noting the same dynamic will be at work in the U.S. “This past week, people are beginning to pay attention.”

He also isn’t necessarily expecting Santa to bring the market gains. “Usually November and December are good because September and October are not. October was just fine. This all comes in the context of a big rally we’ve had, and it’s just an excuse for people to take the metal off the pedal,” Boockvar said. “Markets have had a great run here.”

—By CNBC’s Patti Domm. Follow here on Twitter @pattidomm.

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