Like every story that finds its way into stock market lore, the Santa Claus Rally can benefit investors only if they manage risk accordingly.
What is the Santa Claus Rally?
The Santa Claus Rally refers to a sustained increase in stock prices around the Christmas holidays, likely because of:
- Volatility induced by low market liquidity – because more investors are taking a vacation from their portfolios – which can lead to outsized price swings beyond what a given stock’s fundamentals would predict
- Tax-loss selling, where investors lock in losses to claim tax deductions on capital gains, but buy back into their positions after complying with the Wash Sale rule in the United States and the Superficial Loss rule in Canada
- Upward pressure from the investing of year-end bonuses
- Institutional book settling, which is thought to lead to reduced trading, leaving the market at the whim of retail investors, who have a generally stronger appetite for risk because of their lack of specialized knowledge and market data
- Retail investor optimism during the holidays, leading to a greater propensity to allocate money into the stock market
Yale Hirsch, founder of the “Stock Trader’s Almanac,” coined the term in 1972 to encompass the final five trading days of the year and the first two of the following year, which have collectively offered up a positive return 79.2 per cent of the time through 2012, according to Jeffrey Hirsch’s “The Little Book of Stock Market Cycles.” The Stock Trader’s Almanac, for its part, compiled S&P 500 data from 1950 to 2020 that showed that Santa Claus rallies occurred an impressive-sounding 57 times (81 per cent), yielding average growth of 1.3 per cent, a maximum decrease of about 4 per cent (2000), and a maximum gain of more than 7 per cent (1973, 2009).
In additional Santa Claus Rally history, Sidney B. Wachtel presented his now termed “Santa Rally” analysis in The Journal of Business (University of Chicago) in 1942. The article, entitled “Certain Observations on Seasonal Movements in Stock Prices,” found that “all research on the subject [up to 1925] proved quite conclusively that such movements were definitely nonexistent.”
However, Wachtel does find evidence in support of a December-January rise in the Dow index from 1927 to 1942, with 5-10 per cent increases in 11 of the 15 years, and declines of not more than 4 per cent. His conclusion, that “the seasonal curve is well worth watching when formulating actual investment policy,” is one we share and shall expand upon to end this article.
The Santa Claus Rally concept has since been expanded to include all of December, and further through January, as the given article or analytical report may require, fooling some investors into thinking it has anything but a basis in randomness, as is the case with “sell in May and go away,” the January effect, the Super Bowl indicator and the presidential election market cycle, to name a few.
December data shows Santa Claus to be an unreliable catalyst
To illustrate the empty hope at the heart of the Stock Trader’s Almanac’s 70 years of data, let’s consider the performance of the S&P 500 in the week before Christmas from 2002 to 2021. During this period, investors enjoyed a positive return for 13 weeks (65 per cent), suffered through a negative one for five weeks (25 per cent), and strolled through two with no change (10 per cent), while the index grew by more than 400 per cent across the entire 20-year period.
The data demonstrates that stocks react to fundamentals over the long term, as they always have, and that, while Santa’s jolliness is discernible in stock prices over seven decades, this pattern might turn into a coin flip over periods as long as two decades.
We can reasonably conclude that Mr. Claus’ perceived influence on stocks in December does not act linearly enough to dictate investment decisions on its own, and that it will eventually yield to fundamentals over time.
A short-term trade based on Santa Claus Rally sentiment in December, at least according to S&P and Stock Trader’s Almanac data, then amounts to a lottery-type bet that should be reserved for the riskiest slice of your portfolio and risk-managed through position sizing and/or stop-losses.
January data further confirms a lack of prediction power
Following the Christmas month’s failure to provide investors with an actionable signal, the stock market’s performance in January does just as poorly, with the SPDR S&P 500 ETF posting 17 winning Januarys (57 per cent) and 13 losing ones (43 per cent) since inception in 1993.
That said, the widespread awareness of the Santa Claus Rally might still offer investors with dry powder an opportunity to profit from those who act upon the concept by rote – for example, by investing on the first trading day of the week before Christmas and dutifully exiting their positions on Jan. 2 – rather than by carefully assessing volatility for worthwhile entry points.
A signal for traders and undervalued entry points, with caveats
Despite the Santa Claus Rally offering no demonstrable path to profits, the low market liquidity during the rally’s applicable timeframe does present investors with an environment of increased volatility.
During the week before Christmas from 2002 to 2021, when many investors are more preoccupied with presents than P/E ratios, the S&P 500 exhibited a range between -10.7 per cent (in 2018) and 5.4 per cent (in 2021). This 16.1 per cent swing is right in line with the S&P 500’s annual standard deviation of 15.14 over the past decade, according to Morningstar, condensing a year’s worth of volatility into a week, and making it more likely that a stock on your radar surprises to the up or downside.
To take advantage of these surprises, investors should refrain from allocating money in anticipation of price action induced by the Santa Claus Rally alone, opting instead for enhancing their investment theses with the following support:
- Having up-to-date valuations for stocks in their portfolios and watchlists to buy shares during an excessive downturn
- Identifying catalysts for upside surprises, such as new products, drilling results or financial results, that justify sustained gains over a multi-day or multi-week holding period, which may be supercharged by the sway of a merry stock market myth
Regardless of the due diligence you choose to act upon, it is perennially important to remember that more than 80 per cent of day traders lose money, making the activity antithetical to most people’s investment goals and risk tolerances. A much more reliable investment program involves dollar-cost-averaging into broad market index funds to take advantage of compound interest over a lifetime.
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