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Hundreds of people dressed as Santa Claus start to run, at the annual St. Nicholas Run, in Michendorf about 45 kilometers (28 miles) west of Berlin, Germany, on Sunday, Dec. 9, 2012. (Markus Schreiber/AP)
Hundreds of people dressed as Santa Claus start to run, at the annual St. Nicholas Run, in Michendorf about 45 kilometers (28 miles) west of Berlin, Germany, on Sunday, Dec. 9, 2012. (Markus Schreiber/AP)

Market Outlook

Will a late Santa rally carry into 2013? Add to ...

With the fiscal cliff replacing the U.S. election as a big focus of uncertainty, and the end of 2012 coming up fast, many traders have started to ask “Will we get a Santa Claus rally this year?”

Let’s look at the market trends and focus on four of the factors that could influence the timing and magnitude of a Santa Claus Rally or New Year’s Rally

More Related to this Story

U.S. Fiscal Cliff Negotiations

  • The announcement of a deal could unleash a lot of pent up demand and spark a Santa Claus rally

Impact of Fiscal Deal On Taxes

  • If traders fear that capital gains or dividend taxes may be about to jump, they could sell their winners to lock in gains at a lower tax rate. This could put significant pressure on markets in December but could also pave the way for a larger rebound in January.

Impact of Hurricane Sandy

  • Judging by early indications, in the early part of December we may see a number of disappointing data points reflecting the impact on the U.S. economy from Hurricane Sandy. This could weigh on markets through December as outlooks for Q4 economic growth and corporate earnings are revised downward.

Mayan Calendar Rolls Over on December 21st

  • Psychology plays a big role in markets and trading so that element of uncertainty left in people’s minds about whether the world is going to end or not could keep some bulls on the sidelines for a bit longer than usual. This could push back the start of the Santa Claus Rally to December 22 nd even if a debt deal is done sooner.

What are the Santa Claus and New Year Rallies?

Historically, the end of the year has been a time of reflection and optimism for stock markets where traders tend to rebalance their portfolios start to look ahead to the upcoming year usually with the hope that it will be better than the year just ending.

Toward the end of the year, traders tend to sell their losing positions in order to be able to claim tax losses which can depress stock prices. Not everyone waits for the last minute though so into late December stocks have historically rebounded as tax loss selling pressure subsides. Then into January tax related trading can become a source of demand as traders look to get back into positions. The investment of bonuses and flows of capital into retirement accounts to take advantage of tax deductions also tend to boost demand in the early part of the year.

Does the Santa Claus Rally Really Exist?

To determine if the Santa Claus and New Years rallies really exist, we looked at the average daily return on the S&P 500 for each day in January over the last 10 years and the last 20 years.

Like the rest of the year, markets tend to have their ups and downs through these two months, but over time a clear trading pattern has emerged.

Historically, December has started off strong with a rally running through to about December 5th . Markets then tend to recede between December 6th and 15th , which likely represents the peak period for tax loss selling. The Santa Claus rally then has tended to kick in and run between December 16th and 26th. The last few days of the year tend to be mixed with volumes light and a lot of traders away on holiday.

January has tended to start with a bang with a New Year’s rally running through the first five trading days of the year. The initial burst of enthusiasm has tended to quickly fade after that.

Prospects for a Santa Claus Rally This Year

The rebound in stocks commonly seen from mid-October through the end of the year has yet to materialize in 2012 following an unusually strong September leaving many to wonder if Santa will have presents or a lump of coal for the markets this year.

There is still the possibility of a rebound around the turn of the year but it could be delayed into January.

Some of the factors that could influence the timing and magnitude of a Santa Claus Rally or New Year’s Rally include:

U.S. Fiscal Cliff Negotiations

Unless a new budget deal is reached, a number of automatic tax increases and spending reductions are scheduled to kick in on January 1st. Although it’s generally expected that a deal will be reached in time, the risk that a failure could push the U.S.back into recession has been keeping bulls on the sidelines.

The announcement of a deal could unleash a lot of pent up demand and spark a Santa Claus rally. How much of a rally would depend on whether this is a small deal to start with more negotiations to overhang markets in 2013 or if a grand compromise is reached.

Since any deal is likely to represent a move toward austerity through a combination of tax increases and spending cuts, the impact of a deal could limit the longer term upside for markets.

On the other hand, if politicians don’t go far enough, they run the risk of further credit downgrades (Moodys and Fitch have already put them on notice) which bring their own risks.

Whatever type of deal is reached, we are likely to see significant volatility and trading opportunities in the markets afterward as was seen following the debt ceiling deal in the summer of 2011.

The timing of a deal could impact the timing of a Santa Claus rally. If it’s basically resolved early markets may follow their usual pattern but if negotiations drag on to the last minute, Santa’s arrival could be pushed into January.

Impact of Fiscal Deal On Taxes

Taxes are front and centre in these negotiations and included in this are capital gains and dividend taxes which could have an impact on markets. Traditionally, traders sell their losers near the end of the year to generate tax losses.

If traders fear, however that capital gains or dividend taxes may be about to jump, they could sell their winners to lock in gains at a lower tax rate. This could put significant pressure on markets in December but could also pave the way for a larger rebound in January.

Mayan Calendar Rolls Over on December 21st

The Mayan calendar rolls over on December 21st. Initially regarded as marking the end of an era and a possible harbinger of the apocalypse, more recently it has been seen as potentially representing a time of change.

Psychology plays a big role in markets and trading so that element of uncertainty left in people’s minds about whether the world is going to end or not could keep some bulls on the sidelines for a bit longer than usual. This could push back the start of the Santa Claus Rally to December 22 nd even if a debt deal is done sooner.

Impact of Hurricane Sandy

Judging by early indications, in the early part of December we may see a number of disappointing data points reflecting the impact on the US economy from Hurricane Sandy. This could weigh on markets through December as outlooks for Q4 economic growth and corporate earnings are revised downward. Note that heading into the next earnings season, companies are likely to write down everything that they possibly can using the storm as cover.

Over time, however, this can be discounted and the reconstruction process could provide an economic boost that could help the bullish cause; but this may not emerge until farther into 2013.

Conclusion

The stage appears to be set for a weaker than usual start to December. The deeper the declines, however, could set the stage for a significant rebound. Santa may still come this year with goodies for the markets, but don’t be surprised if he arrives a bit later than usual.

Colin Cieszynski is a CFA, CMT, and Market Analyst with CMC Markets

Follow us on Twitter: @GlobeInvestor

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