Brad here. At this time of year, we hear a lot about seasonal effects, with the Santa Claus rally at the head of the list. Today, Jim McAllister, director of equity research, takes a look at how much is fiction and how much is fact when it comes to the Santa Claus rally. Thanks, Jim!
‘Tis the season when many people are preparing for the holidays and spending time with family and friends. Still, some investors can’t completely detach from the market and continue to seek every little edge. Somewhere along the way, a theory was born that in the wake of the Christmas holiday, equity markets tend to rally and post better-than-average returns. The so-called Santa Claus rally is believed to occur over the last week of trading in December and the first two trading days of January in the new year. In fact, in 2018 there was a strong and very welcomed Santa Claus rally. The S&P 500 gained 4.2 percent after an almost 20 percent correction earlier in the quarter. Although that move is enough to pique investor interest, it doesn’t mean it’s a fail-safe theory. Let’s dig a bit deeper into the data to see if the Santa Claus rally is something worth believing in.
Holly jolly data
In an effort to validate the Santa Claus rally theory, we pulled the S&P 500 performance data for the past 25 years for the last week of trading in a given year, plus the first two days of the new year. We found that the average return during the Santa Claus window was 0.89 percent, with a median return of 1.03 percent. Overall, the market was positive in 69 percent of the years that we reviewed. These results demonstrate a relatively impressive and consistent performance over what is only a five- or six-day trading window. They are even more impressive given the average six-day return throughout those 25 years is only 0.19 percent, with a median of 0.36 percent. In other words, the average and median returns during the Santa Claus window have been three to four times greater than in any old average week during the rest of the year.
The holiday spirit
So, we can see that the data certainly supports the notion of the Santa Clause rally theory. But we also know that short-term trading patterns are generally based on behavioral factors as opposed to fundamental ones. The weeks around Christmas and the new year are typically bereft of meaningful data pertaining to the drivers of long-term performance. That said, we can certainly identify several factors that might contribute to and help explain the impressive results around the Santa Clause rally.
- Positive sentiment: With all the excitement around the holidays and the start of a new year ahead of us, human behavior kicks in and investor sentiment tends to be more positive.
- Low volume: With so many investors opting for time off to celebrate with friends and family, trading volumes tend to be very depressed over the last several trading days of the year.
- Tax loss harvesting strategies: Tax loss harvesting strategies tend to be done earlier in the quarter, so this source of volume has already dried up. And with a new tax season just around the corner, investors contemplating selling their winners are willing to be patient until the new year to delay any potential impact from capital gains taxes.
Beware the Grinch!
These factors can all help explain why the bias after the Christmas holiday is to the upside. But they may also leave the market susceptible to bad news. Unfortunately, this year we have our share of concerns that could hit the headlines at any time. Changes to the current Chinese tariff agreements and much-anticipated economic reports (including those on the GDP, durable goods, initial jobless claims, and consumer confidence) could result in the Grinch crashing the Santa Claus rally party. In addition, there are always those unexpected events, such as terrorist attacks and geopolitical uncertainties, that can become major market movers even when volumes are normal.
Is Santa coming to town?
So, while historical data does support the idea of a Santa Claus rally, it doesn’t necessarily mean it is prudent to start trading around this phenomenon. Compliance departments across the country would be happy to remind us that past performance is not an indicator of future performance. In addition, the short time frame doesn’t necessarily provide significant data to adopt what is essentially a short-term tactical trading strategy. Finally, we know that some of the factors that help explain historical performance might just as well work against the market should scrooges take control while volume is so low.
In other words, there is no sense disrupting a well-established long-term investment strategy to try and capture what may or may not turn out to be a few extra percentage points. Of course, it’s always fun to believe a nice gift may be coming your way. But it’s even more important to understand what factors might help explain the theory, allowing you to have a better appreciation of those years where Santa Claus and his rally do come to town.