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Feature Article

The Santa Claus Rally and Recency Bias

by D.R. Barton, Jr.

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“If Santa Claus should fail to call,
Bears may come to Broad & Wall”

—Old Wall Street Saying, unattributed

My delightful family has lived in the same house for 26 years. We live on the outskirts of the little university town of Newark, Delaware. We had the house built new and have fought the urges to move more than once but with a beautiful little stream running 15 feet from our screen porch, it’s been relatively easy to stay put.

Behind the stream on our property is a forest so we get our share of wildlife in the backyard including foxes, hawks, skunks and possums. Among our most frequent visitors are whitetail deer who find enough tasty vegetation around the stream that they have left the ornamental plants around our house alone — for the most part.

Over 26 years, I’ve seen deer in the back yard hundreds of times — but never once in the front yard. So imagine my surprise when a big buck was standing in my driveway in the front of the house as I drove up at dusk one day last week. Had I been just a little less attentive, we might be eating venison for New Year’s Day.

Here’s the funny thing: Ever since then, I’ve found myself subconsciously wary of hitting a deer as I approach my house. The recent event of almost hitting a deer after 26 years of never seeing one in front yard has become a noticeable bias (hopefully, a short-term one).

The same thing happens to traders and investors in the financial markets. Recency bias is the tendency in our decision making which causes us to overweigh the events that happened last. Today, let’s look at the seasonal tendency called The Santa Claus Rally and make sure we don’t let recency bias cloud our judgment.

Vetting Seasonal Patterns

A seasonal tendency has to pass two hurdles in order for me to incorporate it into my financial decision making: it has to show statistical validity, AND it has to have fundamental support to back it up.

In the past, I’ve shared my analysis on many seasonal patterns using these criteria in Tharp’s Thoughts articles. There have been those that work (e.g. Six Best Months, January Effect) and those that just plain don’t work (e.g. the January Effect and the “First Five Days” indicator which I dissected here: January’s First Five Days Indicator—Forewarned is Forearmed, and here: January As a Barometer: Things Are Not Always What They Seem).

Let’s revisit the Santa Claus Rally today to see why it is on my seasonal pattern watch list every year.

Santa Claus Rally Statistics

In their ubiquitous Stock Trader’s Almanac, Hirsch and Hirsch explored why end of year trading has a directional tendency and they proposed the Santa Claus indicator (they also provided the quote above).

The Santa Claus indicator is pretty simple. It looks at market performance over a seven day trading period — the last 5 trading days of the current trading year and the first two trading days of the New Year. What we find are some compelling stats.

Since 1969, this seven day period has returned positive results in 34 out of 45 years for a 76% win rate and an average gain of 1.6%. Looking back another 20 years shows that the seasonal move holds up with a similar percentage of wins but a modestly reduced average gain.

Santa Claus Rally Fundamentals

As with any seasonal tendency, I take a look for the fundamentals behind the data. In this case, we have two supporting cases for the short term trend — strong investor psychology and a very tangible institutional money reality as well.

On the psychology side — investors and traders are certainly influenced by the mood of the season. Whether you celebrate Christmas or not, it is undeniably the U.S.’s most permeating holiday with a well-promoted theme of joy and good cheer. It is followed up one week later by New Year’s Eve / Day — a near universal celebration in the western world. Spirits are high and optimism is the dominating mood of both of these holidays.

On the institutional side, there is a well-known phenomenon of last minute trading to make portfolio returns look better with techniques that fall under the broad term of “window dressing”. This can range from fairly benign practices like adding hot stocks to the portfolio (so that it looks like the manager was in them all along) to more controversial practices such as bidding up stocks that are already in the portfolio. Here’s some interesting research on the subject reported by Jason Zweig:

“A Wall Street Journal analysis of daily trading in roughly 10,000 stocks since 2004 found that on the final trading day of each quarter, there was a sharp increase in the number of stocks that beat the market by at least five percentage points, then trailed it by three points or more the next trading day.”

While that particular practice takes place mostly in thinly traded stocks, the general yearning for stronger results at the end of the quarter and especially at the end of the year certainly adds to the consistency of the Santa Claus Rally.

There is also the simple reality that institutions and funds have new money coming into them during the first couple of days of the quarter and of the New Year. Money from automatically funded accounts (pensions) and other systematic contributions has to be put to work. This well-known money flow effect causes the first two days of the month and quarter to be better performers on average than any other two day period.

So putting the fundamentals and the statistics together, the Santa Claus Rally does seem to have validity and should be taken into consideration as an input (but not the only input!) for your investing and trading decisions.

Be Wary of Recency Bias

Last year the Santa Claus Rally didn’t happen — in fact, markets dropped 2.9% over the period. But don’t be like my subconscious mind looking for deer every time I pull into my driveway and only focus on what happened recently! Instead, realize that this seasonal tendency does provide an edge and factor that into your year-end investing and trading decisions.

I hope that all the hope, love and joy of this season are with you and your families! And may you have a happy and prosperous New Year!

Your thoughts and comments are always welcome — please send them to drbarton “at” vantharp.com.

Great Trading,
D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured analyst on Fox Business’ Varney & Co. TV show (catch him most Thursdays between 12:30 and 12:45), on Bloomberg Radio Taking Stock and MarketWatch’s Money Life Show. He is also a frequent guest analyst on CNBC’s Closing Bell, WTOP News Radio in Washington, D.C., and has been a guest on China Central Television — America and Canada’s Business News Network. His articles have appeared on SmartMoney.com MarketWatch.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".