Can a Santa rally still happen after the best month in decades?

What is a Santa rally? Why does it happen and can it happen this year after such an epic rally in November?

 

Must know

  • The ‘Santa rally’ has become a fixture in the annual calendar for traders whereby stocks tend to rise in December.
  • What is the Santa rally? On average the S&P 500 has risen 1.5% in December and it rises 73% of the time according to CFRA Research citing data since 1945
  • The tendency for December to be a positive month is explained by portfolio managers ‘window dressing’ their portfolios
  • This year’s Santa rally has possibly been complicated by the huge gains in November. Markets don’t go straight up so December could be a correction of the November gains in 2020.

 

What is the Santa rally?

Quite simply it is a tendency for stocks to rise in the month of December and more specifically from around Christmas to the New Year. Stocks of course do not rise every December or every week before and after Christmas – but there is a clear positive skew in the data.

The idea was first popularised by Yale Hirsch in the 1973 Stock Trader’s Almanac. Hirsch said that the stock market tended to rise in the last five days of the year and the first two days of the New Year.

The best explanation is that portfolio managers ‘window dress’ their portfolios.

 

Window dressing

Window Dressing is when portfolio managers buy stocks that have been performing well and sell stocks with big losses to make their portfolios look good to their investors at the end of a reporting period like the end of the quarter or end of the year.

Investors will often check their holdings at the end of the year to see how they have been doing, but may not actually take the time to check how long those investments have been held. The theory goes that the portfolio manager wants to give their clients the impression that they have bought some of the right things and avoided some of the wrong things.

It’s unclear how much window dressing really takes place anymore given that investors have much easier access to their portfolios via the internet and mobile apps. It might just be that a rise in December has become a self-fulfilling prophecy.

 

Does it really work?

Like anything in the stock market, it doesn’t work every time but enough data has been collected across different markets to show the phenomenon of a Santa rally does exist on average. These two charts from the Stock Trader’s Almanac show the seasonal tendency of the S&P 500 over the last decade (skipping 2009) and over the prior 60 years.

Is (The) Santa Claus (Rally) Real? | Seeking Alpha

 

What about this year?

The S&P 500 just had its fourth best November of all time and Dow had its biggest monthly gain since 1987. As they say “stock markets don’t go up in a straight line” – meaning there are always pullbacks as investors pause for breath even in a bull market. Given the huge gains across November, it seems more likely that there is a pullback through December.

However, as can be seen in the data above, November is the joint second-best performing month so it is typical for gains in November to be followed by gains in December. In fact, in 2019 November was a good up month where stocks broke out of a mid-year range.

The difference this time around could be how big those gains were. November could in effect have ‘borrowed’ gains from December due to the surge in optimism around the covid-19 vaccines.

Putting the seasonality to one side, there are some specific risks heading into this December. The market is pricing in a very rosy outlook whereby almost everything goes right. That includes:

  • Governments and central banks add stimulus
  • Businesses survive the second wave of the coronavirus
  • Vaccines will soon be readily available and see a quick uptake
  • Senate runoffs are won by Republicans, preventing a Blue wave

If any one of these assumptions proves untrue, Santa will have some challenges with his usual rally.

The accumulation of the assumptions has seen a big push into cyclical stocks like banks, energy and industrials. At the same time tech stocks have gained but at a more relatively underperformed cyclical. With all sectors of the market bid up, it doesn’t leave room for rotation within the stock market should the outlook change. That might have to mean across the board selling in order to reduce risk in any adverse scenario over December.

 

Summary

Seasonality, a bull market at record highs and a favourable outlook for the Spring all favour a Santa rally this year. The big November gains and markets downplaying virus risks over the winter are reasons it might be a ‘Grinch sell-off’ instead.

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