Is a Santa Claus rally on its way?

After a rocky year in the stock markets, investors are probably hoping for one thing: a year-end rally. History shows that this might happen, based on the Santa Clause rally phenomenon. So, what is a Santa Claus rally, and will we see one this year?

What is the Santa Claus rally?

The Santa Claus rally is a historically strong period for stocks at the end of the year. This typically happens in the last five trading days of the year and the first two of the new year.

The term was coined in 1972 by Yale Hirsh in the “Stock Trader’s Almanac”. He observed that the S&P 500 gained an average of 1.5% during the seven-day period from 1950-1971. Over the years, we have seen this pattern continue. Since 1945, the market has gained during those days 75% of the time.

Zooming in on the past five years, the S&P 500, Dow and Nasdaq Composite all recorded gains in the Santa Claus rally period, except for the Nasdaq Composite in 2021-22.

Hirsh sees the Santa Claus rally not only as a frequent occurrence but also as an indicator of the performance of the market in the coming year. He famously said, “If Santa Claus should fail to call, bears may come to Broad and Wall”, referring to the location of the New York Stock Exchange on Wall Street. What he means is that in years where there is not a Santa Claus rally, it’s more likely that the following year will not be positive for the market and vice versa.

In some years, like 2008 and 2018, the Santa Claus rallies successfully predicted bull markets for the coming year. However, in other years, 2021 for example, this wasn’t the case. We saw the S&P 500 gain 1.4% in the Santa Claus rally period. But as you probably know, the index entered a bear market in June this year, falling by more than 20% from recent highs. There is no clear evidence of a relationship between Santa Claus rallies and market performance beyond coincidence when the two align.

What causes a Santa Claus rally?

There is not a single cause for the Santa Claus rally, but these are some theories behind it:

• Investors often buy stocks ahead of an anticipated rally in January, known as the January effect.
• The holiday spirit fuels optimism during this time of year.
• End-of-year bonuses or gifted holiday money give people money to invest in the market.
• During this time, institutional investors are on vacation, giving more influence to retail investors, who tend to be more bullish.
• The tax year ends December 31st, so some people may rush to complete trades beforehand.

Will we see a Santa Claus rally this year?

The Santa Claus rally has boosted the S&P 500 by an average of 1.3% since 1969. But there is no guarantee that we will see gains this year. The S&P 500 is down from the beginning of the year. But it is on track to have its best fourth quarter since 1999. According to Bloomberg, the recent rally has been sparked by hopes of a slowdown in inflation and that the biggest interest rate hikes are behind us.

This seems to be true (for now), as we just saw the Fed and ECB slow the pace of interest rate increases. On December 14th, the Fed raised interest rates by 50 basis points, less than the 75 basis point hikes earlier this year. However, the Fed’s Chairman Jerome Powell said there is still a long way to go to get inflation down and indicated that there may be more interest rate increases in 2023. The S&P 500 closed down by 0.6% following the news. On December 15th, the ECB also announced a 50-basis point increase, a smaller hike than the last. However, there will be more to come next year. ECB President Christine Lagarde said, “We should expect to raise interest rates at a 50 basis-point pace for a period of time”. The Stoxx Europe 600 fell as much as 2.5% after this.

While investors responded negatively to the recent interest rate increases and forecasts for future hikes, stocks could still rally at the end of the year and into 2023. We will have to wait to see if Santa Claus is coming to town this year!

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Sources: Reuters, Motley Fool, Seeking Alpha, Corporate Finance Institute, Bloomberg, Wall Street Journal