Santa Claus Rally and January Effect

 

Is the Santa Claus Rally real? It’s a decent question this time of year, especially this year. After August’s crash, the best October in years, and then November’s fast but furious pullback, it’s far from clear whether now is a good time or a bad time to be an investor. So you could be forgiven for turning to a mythical figure in hope of some money-making opportunities before year end.

The “Santa Claus Rally” is so-called because it typically starts in December, and is particularly strong in the week between Christmas and New Year. According to the Stock Trader’s Almanac, the experts on seasonality, the market rises between Thanksgiving and New Year’s about 70% of the time. Over the last 65 years, the average gain has been about 2%.

However, there are some reasons to be skeptical that Santa will visit the stock market this year. The Fed is expected to hike interest rates at their December 15-16 meeting, which could cause a temporary pullback in the broad indexes and larger corrections in more interest-rate-sensitive sectors. But if the Fed doesn’t hike rates, the effect could be even more pronounced, as we saw in September when the Fed’s comments about global economic uncertainty caused a sharp selloff in U.S. markets.

And while October’s rally was welcome, it may have dimmed the odds of a strong Santa Claus rally. S&P Capital IQ Strategist Sam Stovall has published data showing that, since 1945, larger gains in October have tended to correlate with smaller returns in the remainder of the year. In years when the market rose between 0% and 1% in October (43 years in total), the market went on to rally into year-end 74% of the time, notching average gains of 2.8% by the end of the year. However, after Octobers with better than 5% gains, like the one we just had, markets rallied into year-end less than 65% of the time, and the average gains were smaller.

Investors can take solace in the fact that regardless of October’s performance, the market delivers gains in November and December 77% of the time.

What causes the Santa Claus Rally is another question. In an unscientific online poll conducted earlier this week, 55% of respondents expected a Santa Claus rally this year (2,400 votes), so anticipation of the effect could be the reason for it as well.

Another theory is that the strength in the last week of December is primarily caused by traders positioning themselves for the next big seasonal rally, the so-called “January Effect.” The January Effect, which simply refers to the fact that the market tends to do well in January, is actually one of the most reliable seasonal patterns in the stock market. Small stocks and the prior year’s underperformers tend to do particularly well.

There are a number of reasons given for the January Effect; the most frequently cited is that it’s a rebound from tax-loss selling that depresses the market in December. The sellers, the explanation goes, then buy back the losing stocks they sold for the tax offsets in December. New investors may also be tempted by the low valuations.

Another partial explanation says that institutional money managers sell their losers and risky bets in December so they can show clients a more reassuring portfolio at year-end. Then, the explanation goes, these “window dressers” buy back the stocks—or replace them with different small or risky stocks—in January, contributing to the January Effect.

Whatever the reasons, the next two months have historically been a good time to be invested in the stock market, so if you have cash to put to work, keep your shopping lists ready.

Excerpted from Cabot Dividend Investor November 25, 2015


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