A Santa Claus rally is a calendar effect characterized by an increase in stock prices over the last five trading days of December and the first two trading days of January. Yale Hirsch observed the trend for the first time in 1972, saying in “Stock Trader’s Almanac” that the S&P 500 had gained an average of 1.5% over this seven-day period between 1950 and 1971.
The broad market index has increased by an average of 1.3% every year since 1950, maintaining a consistent pattern. In 34 of the preceding 45 years, or more than 75% of the time, the market has risen during these days, which is much higher than during any other 7-day average performance.
Historically, the week following Christmas is famously calm, with prices fluctuating within extremely tight levels. This makes sense when you consider that many market players will make year-end position changes in the week preceding Christmas when liquidity is plentiful. In addition, this lull is presumably the result of market players having a vacation break between Christmas and the New Year.
Why does it happen?
There could be various reasons for a Santa Claus rally, including tax concerns, a general state of optimism and festive joy on Wall Street, and the allocation of Christmas bonuses. As previously mentioned, another theory is that some very large institutional investors, many of whom are more sophisticated and bearish than retail investors, tend to take vacations during this time, leaving the market to retail investors, who are typically more bullish or optimistic about the market.
Additionally, investors could be buying stocks in anticipation of a rebound in January, known as the January effect, which may result from December tax loss harvesting and subsequent reinvestment.
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Others claim that the Santa Claus Rally is associated with higher holiday spending. In fact, some experts say that robust retail spending is viewed as a key economic indicator of the national economy, which in turn encourages positive buying behavior. In expectation of solid quarterly returns, retailer stock prices tend to rise in response to year-end sales statistics that are above average. These two factors are believed to have a domino effect on the remainder of the market, resulting in a widespread uptrend move.
Trading the pattern
Market participants pay attention to cyclical trends and occasionally identify opportunities to leverage previous patterns. However, randomness is always a factor, and the Santa Claus rally is no exception. Those who trade seemingly regular patterns often do so regularly over time by limiting the amount of risk and profit they assume through position size, stop-loss orders, and cutting losses early if prices go against them.
Observing the Santa Claus rally is one thing, but trading the so-called phenomena profitably is quite another. A good set of principles for doing so involves selecting a stop-loss level and having a strategy for what to do if the trade is neither successful nor stopped out by New Year’s Eve.
In December 2008 and January 2009, for instance, a large Santa Claus rally took place. The S&P 500 gained 7.36% for the seven-day span beginning December 24th, 2008, and ending January 5th, 2009. This surge provided some relief to the index, which had plummeted more than 40% since the beginning of the year.
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Some investors view Santa Claus rallies as indications for the upcoming year. If a year ends with a Santa Claus rally, the next year is anticipated to be bullish. If the rally does not occur, the next year could be bearish.
According to statistics gathered by LPL Research and FactSet, the S&P 500 fell 4% during the Santa Claus rally period in 1999, and the Dotcom bubble burst in 2000. Similarly, the S&P 500 fell 2.5% on the same trading days in 2007, and 2008 saw the Great Recession.
The graph below depicts the percentage change of the S&P 500 stock market index during the final five trading days of the year and the first two trading days of the new year.
Source: Data calculated from S&P 500 Index E-mini Futures Continuous Contract from TradingView
Never a 100% probability in markets
As with other calendar patterns, such as the January effect and expressions such as “Sell in May and go away,” there is substantial evidence that the Santa Claus rally is legitimate and can accurately forecast the market’s future.
However, it would be a mistake to mix correlation with causation in this case. The fact that the Santa Claus rally often occurs and frequently predicts the market for the next year does not imply that it will continue to do so. The market mood might fluctuate. If investors anticipate a Santa Claus rally, they are likely to behave differently, and market participants may respond accordingly.
Nonetheless, investors should be mindful of how the market fluctuates throughout the year. Although there is no definite anticipation for the Santa Claus surge, end-of-year stock performance has historically been encouraging.
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