The Santa Claus Rally is often misnamed so that any rally in December seems to be classed as the Santa Rally, which is not correct.
A Santa Rally is one particular phenomenon that falls within the broader subject of market seasonality.
Market seasonality is the study of historical data to discover patterns which may repeat at certain times of the year (also known as the 'calendar effect').
Seasonality is a characteristic of a time series in which the data experiences regular and predictable changes which recur every calendar year. Any predictable change or pattern in a time series that recurs or repeats over a one-year period can be said to be seasonal.
Note that seasonal effects are different from cyclical effects, as seasonal cycles are contained within one calendar year, while cyclical effects (such as boosted sales due to low unemployment rates) can span time periods shorter or longer than one calendar year.
Seasonality can be seen in many time series, and it's more common than you might think. For example, if you live in a climate with cold winters and warm summers, your home's heating costs probably rise in the winter and fall in the summer. You would reasonably expect the seasonality of your heating costs to recur every year. Similarly, a company that sells sunscreen and tanning products would see sales jump up in the summer, but drop in the winter. Companies that understand the seasonality of their business can time inventories, staffing and other decisions to coincide with the expected seasonality.
It's important to remember the effects of seasonality when analyzing stocks from a fundamental point of view. For example, if you assumed a sunscreen company was going to earn as much in the next three quarters as it did during the recent summer quarter, your earnings estimates would likely be way off the mark!
Another Example of Seasonality
Historically the stock market has seen most of its gains between 1st November and 30th April. This led to the old saying
“Sell in May and go away, don't come back 'til St Leger day” – as the period between May and October tends to be the weakest, with September being a very weak month for stocks (and when the St Leger horse race is run).
Seasonality is a guide it’s not a guarantee – but it appears, looking at history, seasonal patterns do repeat and can give you a good guide to your future investing strategies.
Santa Claus Rally
Santa's origins are a matter of speculation, but according to popular belief, he is derived from a Dutch mythical character based on the historical figure Saint Nicholas, who supposedly gave presents to the poor. The modern-day Santa spends his time spreading cheer and promoting world peace by delivering gifts all over the globe.
In the investing world, Santa brings investors a "gift" in the form of a jump in the price of stocks, known as the Santa Claus rally.
A 'Santa Claus Rally' is a surge in the price of stocks that often occurs in the week between Christmas and New Year's Day.
The real Santa Claus Rally is in fact a very short window and starts the last five trading days of the year and the first two trading days of the New Year.
There are many theories as to why this happens:-
• Some people believe it is a result of year-end tax considerations,
• Others say it's because all the market pessimists are away on holidays, or
• People are buying stock in anticipation of the January effect.
The January effect is also a stock market phenomenon that occurs at the end of the year as investors begin to fret over taxes. Investors whose portfolios have been very successful may sell any stocks that are down. This locks in the loss and allows the investor to write it off against his or her capital gains. When enough investors do this simultaneously, it causes stocks to go down near the end of the year.
However, the stocks are driven back up in January when investors buy back the stocks they sold. The January effect is said to affect small caps more than mid/large caps, but it has not happened in years because the markets have adjusted for the effects. Also, more people are using tax-sheltered retirement plans. The tax shelters remove any reason for selling in order to create a tax loss. Thus, in recent years, the January effect has become somewhat of a non-event - much like the tradition of making New Year's resolutions.
• Those that believe in the magic of Christmas think the rally may be due to seasonal cheer infecting the usually dour inhabitants of Wall Street - a true Christmas miracle.
• The simple combination of a feel good sentiment may be considered.
• Lower volumes as many senior traders take the end of the year off will have an effect, and
• General year-end window dressing with the combination of an end of month and year may also help.
Since 1928 until/and including 2010, the U.S. stock market has rallied in December 74.7% of the time.
Historically, during those seven trading days, the typical gains have been 1.5% to 1.7% over the last 50 years on the S&P 500 and the Dow Jones.
Another interesting point to consider - when the market is down in November, it rallies 80% of the time.
Santa Claus Rally Summary
To sum up, the real Santa Claus rally is fairly short and, while nothing is guaranteed, the last five trading days and first two trading days of the New Year have a very strong track record.
Once the Santa Claus rally concludes take the road of caution – markets usually revert somewhat – play the game accordingly!