There’s a song called Christmas in Australia that goes like this:
“Christmas in Australia is Christmas in Paradise;
Christmas in Australia is basically bloody nice!”
And so it is, but not necessarily because of the weather. Let’s talk about why. For decades, investors have been benefitting from a positive end-of-year stock market trading phenomenon called the “Santa Claus Rally.”
Is this for real, and should we expect to see anything this year despite fiscal cliff anxieties?
The History of the Santa Clause Rally
The Christmas effect was first publicly noted in the early 1970s by the legendary stock market technician and historian Yale Hirsch, author of the Stock Traders Almanac. Hirsch was constantly looking for exploitable patterns in stock market behavior that allowed investors to time the market and eke out some excess return in addition to those experienced by buy-and-hold indexers. Hirsch noticed that stocks had a high likelihood of a rally at the end of the year – between Christmas and New Years.
Why? Who knows? Some say it’s due to mutual fund managers “window-dressing” their portfolios so as to show a portfolio of popular stocks for when the new annual reports are published using year-end data. Others say the phenomenon is just due to random chance.
That may have been the case with another of Hirsch’s ideas, the January Barometer. This was the notion that January was a useful predictor of stock market profits or losses for the remainder of the year. That was true using backtested data from the 1950s through about 1994. At that point, though, the January Barometer lost its mojo. It now has no predictive value at all. This frequently happens when too many traders find out about a historical anomaly; they trade it so much that all the usefulness gets ironed out of it.
Other observers will tell you that trying to time the market and looking for trading patterns is an exercise in futility. Former Vanguard chairperson and Princeton Professor Burton Malkiel, author of the pro-indexing, anti-market-timing book A Random Walk Down Wall Street, goes into terrific depth about why past stock movements cannot be useful predictors of future performance. And there’s something to be said for that point of view: Year after year, the DALBAR quantitative survey of investors shows that individual investors – a group that includes market-timers and traders – drag the broad market terribly.
Is the Santa Clause Rally Real?
Market-timers are notorious for data-mining – an investment and logical fallacy in which people plum data sets trying to identify patterns that are really explainable by random chance – like a coin toss coming up ‘tails’ five times in a row. Just because it happens sooner or later, this doesn’t mean if you flip enough coins you can predict when it will happen again.
But so far, there does seem to be something behind a holiday-season rally. Why? Because here we are, years after Yale Hirsch made the Santa Claus Rally common knowledge among the trading community – an event that the efficient market theorists would predict would cause any trading advantage to vanish – we still have a statistically significant and tradable tendency for stock prices to increase during the holiday season.
Using this online tool, we see a powerful tendency for stocks to rise in December, between 1957 and 2011. There were 47 positive years against only 15 negative years, with an average return for December of 1.62 percent. (The last negative December we had was 2007, which saw a decline of 0.76 percent).
But has the December effect become less valuable more recently? Not much. Looking at the last 10 years, Santa has still been good to investors in the month of December: 8 good years and three down years, with an average return of 1.18 percent.
It’s Not the Santa Claus Rally – It’s Bigger Than That
Hirsch’s original observation was that the rally would typically come right after Christmas, and last through December 31st. But Daniel Putnam has run the numbers. His finding? Santa still comes to Wall Street. He just comes during Thanksgiving Week, and stays longer:
In the past 10 years, the S&P 500 has averaged gains of 1.66% and 1.24%, respectively, in November and December, with an average two-month return of 2.90%. In the 20-year interval (1991-2010), the November and December returns are 1.28% and 1.99%, with a two-month average of 3.27%. These are small numbers on paper, but on an annualized basis they are comfortably ahead of the actual returns in most of the individual calendar years.
Digging a little deeper, we can see where these returns are concentrated. The data show that the best returns within the November-December period have occurred on Thanksgiving week, and in the week before the week in which Christmas falls. Christmas week itself also has been very positive on a 20-year basis, but this is largely due to the strong returns registered from 1991 through 2000.
Mark Hulbert, the editor of the Hulbert Financial Digest, also takes a look at the phenomenon. He’s less enthusiastic about the month of December… lending more weight to more distant time periods. Yes, December has gone through some strong periods, but it has also gone through periods earlier in this century when it was nothing special.
Hulbert’s calculations show that some real action does occur between Christmas and New Years:
Since 1896, for example, the Dow between Christmas and New Years has risen 78% of the time, producing an average gain of 1.06%. That compares to an average gain of just 0.10% across all other 4-trading-day periods since 1896, over which the Dow rose just 55% of the time.
Will this year be different?
Is there reason to believe that December of 2012 will be a down year? Well, there is at least one significant issue at play this year that wasn’t an issue in prior years: The imminent increase in the federal tax on qualified dividend income. Unless Congress intervenes, the favorable 15 percent top tax rate on qualified dividends vanishes, and dividends will be taxed as ordinary income.
This brings up an important concept: the idea of tax capitalization. This is the financial theory that taxes have a material effect on asset prices: As taxes on a given asset increase, investors bid down prices so that after-tax returns remain relatively stable, all else being equal.
Since taxes on dividend income and capital gains income are both going up, this knowledge is going to exert some downward pressure on stocks. John Waggoner, the longtime finance columnist at USA Today, explains how tax capitalization in this context works:
“Under current law, a person in the 35% tax bracket would owe 15%, or $45, in taxes on a $300 dividend payout. Your after-tax dividend payment would be $255, and your after-tax dividend yield would be 2.55%.
If Congress allows the Bush tax cuts to expire, the tax on a $300 payout would soar to $118.80, leaving you with $181.20. Your after-tax yield would plunge to 1.81%…
…All other things being equal, the most likely way to increase the yield is to reduce the stock’s price. Given that dividend-paying stocks have been popular lately, the price reduction in dividend-paying stocks could be substantial. Suppose you wanted your 1,000 shares of Wholy Moly to yield 2.55% after taxes again. If the after-tax dividend were $181.20, you’d have to drop the price to $7.11 — a 29% drop — to equal a 2.55% after-tax yield.”
Which brings us back to Australia. The strongest tendency to Christmas cheer we could find in an actual investable asset comes from out back in the land down under: The “all ords” index from the Australian Stock Exchange.
“Buy the All Ords Index in the week of Christmas , that is enter the trade on the last trading before the week where Christmas falls ( for 2011, it is buy at close 16 December 2011, and exit the trade at 23 December 2011.”
This strategy historically yields profits 85 percent of the time, with an average profit of 1 percent per trade. Not a bad strategy for a week’s time.
Good luck out there finding investments that may not be significantly affected by the dividend tax hike.
Disclaimer: The views and recommendations in this piece are held by the contributor alone and do not necessarily reflect the opinions of NerdWallet.