Will there be a ‘Santa Claus rally’ in the stock market this year?

in 1897, American newspaper editor Francis Pharcellus Church famously wrote a reply to a young reader who had doubts about the existence of a certain old man in a red suit who spent a lot of time near chimneys: “Yes, Virginia, there is a Santa Claus. “.

The average investor is a little older than eight-year-old Virginia, but this is the time of year when they’re putting out their own questionable version of this question — namely, will there be a “Santa Claus rally” before the end of the year ?

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In the jargon of the financial press, the Santa Claus rally refers to an expected increase in stock market returns at the end of the year. The reference to Christmas is actually a bit misleading, as the rally usually refers to the last five trading days of the old year and the first two trading days of January.

Unlike the old man in red, there is certainly no doubt that Santa Claus rallies exist. They failed to visit Wall Street only five times have created a profitable opportunity over the past 20 years to buy stocks just before the rally starts and then sell them just before it ends. Not only that, the absence of a Santa rally was associated with a weaker January, making it an important indicator.

What explains the Santa Claus rally?

However, according to economic theory, the Santa Claus rally should not exist. Nobel laureate 2013 Eugene F Famas The theory of market efficiency says that stock prices should capture all available information about companies and the broader economic outlook, making it impossible to use past market trends to predict future prices.

Indeed, there are several other explanations for Santa Claus gatherings. It’s the end of the US tax year, when investors tend to sell some assets at a loss to claim capital gains exemption. Institutional investors go on vacation, leaving more traders in the market who may be less cautious or informed. In addition, there will be individuals investing their year-end bonuses while prices can be moved more easily at a time when the transaction volume in the market is quite low.

Yet this is not the whole story. Just as the ancient Romans believed in the influence of the calendar on everyday life, the days sorted into glories (good days) and shameful (bad days), there is ample evidence that something comparable happens on the stock exchanges.

Back in 1931 a Harvard graduate student named MJ Fields wrote a paper identifying a “weekend effect”, where Friday tends to generate higher stock returns, while Monday is usually associated with lower ones. Since then, researchers have been able to identify numerous other shifts in returns associated with particular times in the calendar.

According to the “January effect”, usually significant gains are made in the stock market in January, mainly due to the shares of small companies. There is a “turn of the month effect”, related to the first four trading days of the month, and a “holiday effect”, with pre-holiday days yielding higher returns than the average. Even the time of day important, as opening prices are usually higher for the first 45 minutes on a Monday, in a sort of “extension of the weekend effect”.

So how does all this reconcile with the idea that ultra-rational traders make decisions with all available information at their fingertips? Behavioral economics is helpful here with her ideas about the psychology of decision-making, much of which stems from the work of another Nobel laureate, Richard Thaler, who won in 2017.

This boils down to the idea that investors’ feelings can influence their trading behavior: gloomy moods on Monday as they go back to work, the uplifting Friday feeling of the coming weekend, and of course Christmas cheers and the optimistic feeling of a new year just around the corner. .

However, there are caveats. To start with, the huge turnout of trading bots in recent decades – they now control more than half of US stock trading – undermining the idea of ​​emotionally sensitive traders. Trading bots definitely don’t get it when they go back to work on Monday.

More generally, we need to be careful not to read too much about calendar effects. We conducted a simple experiment by looking at the correlation between stock market returns and one of our birthdays. This should obviously be irrelevant to the FTSE, and yet it turns out to be a bad day for trading, yielding negative returns of 65% over a number of years. So it looks like we can add the “birthday effect” to the list of red letter days.

What to expect this year?

The charts below show the past six years of returns in the FTSE during the holiday season (click to enlarge). They show that Santa was not at all on Wall Street in 2015 and not always easy for investors in other years either: you still have to time your buying and selling properly. So while the odds of a Santa Claus rally in any given year are quite high, keep in mind that the outlook isn’t as rosy as historical averages suggest.

Festive FTSEs, 2015-20

So will festive 2021 be the season for investors to rejoice? It’s so hard to predict these things in advance. Especially with the dark shadows of rising inflation, central banks tightening monetary policy, concerns over government debt, rising energy prices and new waves and variants of COVID, a Santa rally may seem like a much-needed Christmas present.

But if it does happen, be wary: Once the January optimism is over, there are currently many reasons to think more losses lie ahead.

Gabriella Legrenzi, senior lecturer in economics, Keele University; Reinhold Heinlein, Senior Lecturer in Economics, University of the West of England, and Scott Mahadeo, Senior Lecturer in Macroeconomics, University of Portsmouth

This article was republished from The conversation under a Creative Commons license. Read the original article.