Santa rally: Season of goodwill may yet fall flat

This article is part of
Near-Term Market Trends - December 2013

December and January is a period of reflection and optimism for stockmarkets, but they face a number of big changes and potential risks in the coming weeks.

This leaves us to wonder whether Santa will have any goodies for the markets this year or whether the Grinch will get there first.

Toward the end of the year, traders tend to rebalance their portfolios and look ahead to the new year. They might sell their losing positions to claim tax losses, and this can depress stock prices.

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Not everyone waits until the last minute, though, so stocks usually rebound into late December as tax loss-selling pressure subsides. Then, into January, tax-related trading can create demand as traders look to get back into positions. The investment of bonuses and flows of capital into retirement accounts to take advantage of tax deductions boosts demand early in the year.

Analysis of the average daily return on the S&P 500 index for each day in January in the past 10 and 20 years goes some way to determine whether the Santa Claus and new year rallies exist.

Markets have their ups and downs during these two months, but over time a clear trading pattern has emerged.

December usually starts strongly, with a rally up to about December 5. Markets recede between December 6 and 15 – the peak period for tax loss selling. The Santa Claus rally then runs from the 16th to the 26th. The last few days of the year are often mixed, with volumes light and many traders on holiday.

A rally is common in the first five trading days of the year, although it tends to fade quickly, with markets historically sagging in the middle of the month, particularly between the 11th and the 17th, then trying to stabilise towards the end.

Since 2000, the five best days for stocks in these two months have been December 5, 14, 16, January 3 and 23, with average gains of 0.5 per cent or more. The worst days have been December 20, January 20 and 22, with average losses of more than 0.5 per cent.

This confirms the pattern of market strength in early to mid-December and the potential for weaker markets later in January. Some of that strength comes from a seasonal rebound from historical weakness between August and October. This year, however, that correction didn’t really materialise, in spite of October’s US government shutdown and budget crisis.

Near the end of the year, key US indices remain in uptrends that have been intact for more than a year, with only small corrections along the way. Because so many markets have advanced through the year there may be less tax losses to take, reducing the potential overhang.

On the other hand, the trend of the past year, which has been supported primarily by the influx of cash from the US Federal Reserve’s QE3 programme, may be nearing exhaustion. This means markets may have already priced in high expectations for the coming year, which could limit the upside of holiday season rallies.