What Is a Santa Claus Rally?
A Santa Claus rally describes a sustained increase in the stock market that occurs in the week leading up to Dec. 25. However, there seems to be some disagreement over whether these rallies happen in the week leading up to Christmas, or if it's the week after Christmas until Jan 2.
Looking at past price history, the week after Christmas is notoriously quiet and prices tend to move sideways in very narrow ranges. This makes sense if you think about it, as many market participants will take care of year-end position adjustments in the week before Christmas, while there is still plenty of liquidity. Further, this lull is most likely due to market participants taking the holiday break between Christmas and New Year's. As such, for the purposes of this article, we will assign the week leading up to Dec. 25 as having the greatest potential for a "Santa Claus rally."
There are numerous explanations for the causes of a Santa Claus rally, including tax considerations, a general feeling of optimism and seasonal happiness on Wall Street, and the investing of holiday bonuses. Another theory, as mentioned, is that some very large institutional investors, many of which are more sophisticated and pessimistic than retail investors, tend to go on vacation at this time, leaving the market to retail investors, who tend to be more bullish, or positive, toward the market.
- The Santa Claus rally refers to the tendency for the stock market (specifically, the S&P 500) to rally over the week leading up to Christmas (Dec. 25).
- Theories for the Santa Claus rally's existence include increased holiday shopping, optimism fueled by the seasonal spirit, and institutional investors settling their books before going on vacation.
- Historical stock market performance over the last two decades (from 2002-2021) shows just a small positive average return (+0.385%) for the week leading up to Christmas.
- As with many market anomalies, the Santa Claus rally may just be random; there is no guarantee it will appear in the future.
Understanding the Santa Claus Rally That Wasn't
To see if there is any validity to the proposition of a regularly occurring Santa Claus effect, we looked back at the last 20 years of performance of the Standard & Poor's 500 (S&P 500) in the week leading up to Dec. 25. Based on our review of the data, we can state that there is minimal evidence of any discernible Santa Claus rally. The average return over the time period was +0.385%, or effectively flat.
Of the 20 weeks we analyzed, there were 13 weeks with a positive return, five with a negative return and two weeks with no change. The range spanned +5.4% in 2021 to -10.7% in 2018. Of the winning days, the average win was +1.58%, while the average losing day was -3.28 %. We think the numbers bear out the conclusion that there is no reliably meaningful Santa Claus rally. The chart below shows the performance of the S&P 500 in the week leading up to Dec. 25. over the last 20 years:
Given such a small historical return, and a marginally positive frequency of occurrences, traders should be extremely cautious about buying or selling based on the supposed Santa Claus rally. While Santa Claus can be counted on to deliver the presents on Christmas, the stock market cannot be relied upon to always deliver gifts. That said, any positive gain in the stock market around Christmas is virtually guaranteed to lead financial market observers to refer to the Santa Claus rally.
To the extent it exists, many consider the Santa Claus rally to be a result of people buying stocks in anticipation of the rise in stock prices during the month of January, otherwise known as the January Effect. Also, there is some research that points to value stocks outperforming growth stocks in the month of December overall. Of note, many stock pickers in actively managed mutual funds tend to invest in value stocks.
Financial columnists and traders like to opine on the likelihood of a Santa Claus rally. Some cite economic and technical analysis, and others offer pure conjecture.
Trading the Santa Claus Rally
Traders pay attention to cyclical trends and, at times, find ways to exploit historical patterns. But it's always a relatively random proposition, and the Santa Claus rally is no exception. For those who do trade ostensibly regular patterns, they tend to do so repeatedly over time, by limiting both the amount of risk and reward they take on via position-sizing, stop orders, and cutting losses short if positions go against them.
Observing the Santa Claus rally is one thing, but actually trying to profitably trade the so-called phenomenon is another matter. A useful set of rules for doing so includes considering a stop-loss level and having a plan for what to do if the trade is neither profitable nor stopped out—meaning what happens to a trader who sets a trailing stop loss to capture profits from long-running trend trades—by Christmas.
None of this is useful for most investors who do not have the trading experience to manage risk in such short time frames. For buy-and-hold investors and those saving for retirement in 401(k) plans, for example, the Santa Claus rally does little to either help or hurt them over the long term. It is an interesting news headline happening on the periphery but not a reason to become either more bullish or bearish. A better strategy is to maintain a long-term investment outlook and not be tempted by the promise of Santa Claus rallies or the January Effect.
What Causes a Santa Claus Rally?
Several theories try to explain the Santa Claus rally, including investor optimism fueled by the holiday spirit, increased holiday shopping, and the investing of holiday bonuses. Another theory is that this is the time of year when institutional investors go on vacation—leaving the market to retail investors, who tend to be more bullish.
Is the Santa Claus Rally Real?
Our analysis cited above suggests there is only a marginally positive opportunity in trading the so-called Santa Claus rally. The data that we examined shows a roughly 60-65% chance of a positive week in the run up to Dec. 25. However, the risk-reward balance is decidedly skewed to the negative side. Of the average winning day in the period, the return was +1.85%, while the average losing day was -3.28%. Over the last 20 years of following the Santa Claus rally proposition, the average return was only +0.385%, which we do not consider a viable trade opportunity for any but the most nimble of traders.
Will There Be a Santa Claus Rally This Year?
There is no way to know for sure. Traders are commended to ignore the talk of a Santa Claus rally and instead stay focused on their own trading strategy and analysis. The historical statistics we looked at above suggest slightly better than 60-40 odds that a stock rally will take place around Christmastime. However, there are also data points that suggest the rally is more of a 50-50 shot. According to our analysis cited above, the average positive gain over the last two decades is +1.85%, while the average loss was -3.28%. To be forewarned is to be forearmed.
The Bottom Line
Stock market commentators and market pundits love to turn any market gain around Christmas into a so-called Santa Claus rally, because it gives them something to talk about and it explains a day's gain at that time of year. The reality is that statistics put the proposition of a Santa Claus rally on the order of a 60-40 split. Not necessarily a firm basis to be long the market heading into Christmas. The risk/reward proposition (how much you're likely to win on a winning day versus how much you could lose on a losing day) is also decidedly negative. Over the last 20 years, the average winning day was just +1.85% against the average losing day of -3.28%, making the Santa Claus proposition even less attractive.
Instead, long-term traders should view holiday-season price action for what it is: A toss-up amid low market liquidity, with little or no predictive power for the coming weeks. End-of-month and end-of-year position adjustments can produce highly volatile market movements. But just around the corner lies the start of a new year, with investors eager to set positions for the coming weeks and months.