We are entering one of the most interesting annual time periods in the stock market. Most investors have heard of the Santa Claus Rally and the January Effect, but do these phenomena still persist? Does the time period between mid-December and early January truly produce measurable market outperformance as compared to the rest of the year, or is this notion just a myth — an old statistical fluke that has long ago vanished?
In this post, I’ll be taking a close look at the data and exploring some possible explanations for what I find. Because surely, if such a pattern once was sufficiently strong to generate these labels, then the mere discovery of it should have caused shrewd traders to arbitrage the advantage away.
Thus, if the anomaly has persisted, then there must be good reasons. I’ll lay out out some tried-and-true theories as well as newer ideas, that tie in with some of my recent articles.
I will also look into the particular dynamics that are relevant to this year.
Is the effect still visible today?
Initial research quickly reveals that there is a lot of data analysis available that covers monthly seasonality. It shows that December, historically, is indeed one of the best performing months of the year — in the US, as well as internationally.
“The S&P 500 index has grown at an average rate of 1.4 percent in December since its launch in 1928. For the Dow Jones index it was 1.32 percent. The last month of the year was the strongest on average for both indices.” DWS
This is a considerable effect, and a strong base case, but not an edge worth betting the farm on.
But what about January? Digging a little deeper reveals that the majority of the year-end outperformance in the past has actually taken place in a short time period at the end of December crossing into January. In 1972, Yale Hirsch, author of the Stock Trader’s Almanac, coined the term “Santa Claus Rally.”
It describes a narrow 6-day time window (the first trading session after Christmas day until the second day of January) in which this outperformance has indeed persisted, as is confirmed by recent data.
“Since the inception of SPY in 1993, the Santa Claus rally has produced a gain 17 out of 26 times (about 65% of the time.)” Investopedia
— A distinct edge, but again not extraordinarily better than the base rate of 57% of returns being positive on a weekly basis (S&P 500 return distribution from 1928 – 2019). A graph makes clear, however, just how strong the end-of-month and end-of-year effects are in the average size of returns.
Re-evaluating Hirsch’s time frame, by integrating additional return data since 1972, makes the whole story even more convincing.
A seasonal chart shows a much wider time range of outperformance when averaging historical returns from 1928 to 2019 (the area shaded in blue). This new range encompasses the Santa Claus Rally (which has shifted forward in time) as well as the January Effect, the two of which combine to span from December 17th to January 4th.
The effect still is very real, but spread out over a wider time period than it used to be.
“Over the past 91 years the average gain amounted to 1.82 percent over 17 calendar days. Thus the (extended) Santa Claus Rally generated an annualized return of 47.41 percent on average! For comparison: the average annualized gain of the S&P 500 Index in the rest of the time amounted to just 3.90 percent. Prices rose in 79.35% of all cases since 1927!” Seasonax
This result actually points to a much stronger edge than suggested by most commonly cited data, which either concentrates on analyzing a shorter time period (the classic Santa Claus Rally, which has probably become front-run since the pattern became widely known) or separates the effect into two parts — an overall strong December, followed by the January Effect.
Potential reasons for the anomaly
The classic explanation for the year-end / beginning-of-year (EOY/BOY) effect is a combination of portfolio rebalancing and of newly invested capital, presenting a fresh flow of liquidity into the market.
- Tax loss harvesting leads to increased selling of stocks that have performed poorly over the course of the year, which puts pressure on the market earlier in the month of December.
- Window dressing then leads institutional investors to redeploy the freed-up capital into well performing equities, in time to make their yearly results look good (an important factor to boost year-end bonus payments).
- New capital is added as annual bonuses are invested in the stock market and as insurance companies and pension funds pile their existing cash into equities ahead of expected fresh capital at the start of the new year.
The majority of the time, these structural, and therefore repetitive, positive liquidity flows create a reliable momentum acceleration.
The Christmas to New Year period is one of the lowest liquidity environments of the year, as institutional books are closed for the holidays. Retail investors now have the ability to boost the market for a few days all by themselves, as they reposition for the new year (investing their holiday bonuses and other excess savings).
Second order effects from the options market
This structural liquidity loop now meets with second order effects, which are not usually part of the classic theories for explaining the anomaly. As the holiday-shortened period is heading into a big option expiration date in January, option dealer positioning will lead to accelerated reduction of Gamma exposure hedging, supported by Charm and Vanna flows.
Looking closely at the chart above, it is visible that the average seasonal bottom falls around December 15th to 17th. It is no coincidence that this is exactly the time of quarterly expiration in VIX futures and SPX options, as Vanna flows are closely tied to these expiration dates.
In plain English, this means that, as the market begins to rise amid falling volatility (due to the positive first order liquidity flows) and time passes, market makers must mechanically reduce their hedges by consistently buying stocks or index futures. This increases the upward pressure on the market in a positive feedback loop.
This year’s tendency toward large amounts of call option buying may lead to an additional squeeze up, as dealers need to hedge short call positions by buying the underlying securities.
These mechanical flows into stocks now meet a low liquidity environment and a compressed time period, which increases and accelerates the positive effect. In the beginning of the new year, as normal liquidity returns, this fresh inflow is supportive of the January Effect. (Very often we see a rotation from momentum-driven growth stocks into small caps, which tend to see an especially pronounced effect.)
“Long story short. Nov 1 is the kickoff to positive flows. They run through Nov OpEx and coming out of Oct have room to run through Jan 15. But they run out of gas and need to take a pit stop after what’s historically a strong run into Dec 10, so Vanna allows a sideways motion and a correction in time, allowing for a second run, which starts in the Vanna accelerated holiday week of Christmas and continues into the most bullish two weeks of the year, Jan 1-15. The January effect is a bigger factor here than most people realize.“ Cem Karsan, Options Quant, Founder, AEGEA Capital
On the other side of the coin, this tight setup is also vulnerable to a self-reinforcing selling cycle, as we saw in 2018. Such a sell-off, however, is far less likely to occur historically. This bodes well for our current situation, especially if we get through the immediate window of potential weakness around the December option expiration.
“Once this week (post Dec OpEx) seems to be resolved the window dressing for EOY and front running of January effect flows … move front and center, and paired with building Vanna flows and technically bullish signals from market digestion lead to a benevolent feedback loop.“ Cem Karsan
Potential headwinds in 2020
We were heading into an equity pullback (December 9 to 15, at the time of this writing) just before the December OpEx week, with high bullish expectations, a very strong November, and extended positions in stocks. Considering exuberant sentiment, high flying IPOs, and excessive call option buying by retail traders, some market weakness was to be expected.
The argument could be made that the year-end rally has already been front-run in November, with the largest two-week flow of cash into equity funds ever recorded. However, a valid counterargument is that previous outflows throughout 2020 were even bigger, and that momentum often begets momentum.
But rebalancing flows, as many funds keep their allocation between bonds and stocks at set percentages, may lead to an exodus of around $300 billion from global stocks by the end of the year, according to JPMorganChase & Co. The same firm, however, sees a much greater increased demand outlook for equities in 2021 (by >$1 trillion), so the rebalancing effect should be temporary at best.
Furthermore, the December of an election year has historically seen an even stronger year-end effect due to the temporary lull in demand caused by pre-election uncertainty. This year, that uncertainty started to normalize in the beginning of November and may gradually continue to ease until the control of the US Senate is decided in the Georgia runoff elections in January.
Good luck with your investments, and thank you for reading!
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