83% Chance the Santa Rally is Real. How Will You Be Trading?

According to new data, there is an 83% chance that the Santa Claus rally is real. Never heard of the phenomenon? Don't worry. In today's article we discuss what the Santa rally is, what causes it and how you can start trading it today.

What is the Santa Claus rally?

As the name suggests, the Santa rally is a term used to describe the tendency for the stock market to post positive results in the run up to Christmas and the New Year. While it doesn't happen every year, the statistics speak for themselves:

• In US indices, like the SP500 CFD, a rally in the last five trading days of the year and the first two in January has yielded an average 1.3% gain since 1950, with positive returns 75% of the time since 1969.

• The FTSE100 CFD, which represents the UK stock market, has risen 83.3% of the time in December. Its average gain has been 2.4% for the month since 1987.

Whether traders and investors believe in the seasonal tendency or not, one can't ignore that the probabilities are skewed in the favour of a rising market during the end of the year.

What causes the Santa rally?

There is no clear research on what causes this seasonal tendency towards the end of the year. However, here are a few theories on why the markets tend to rally in December:

• More people are on holiday. This means short sellers are away, leaving algorithms building long positions for investor portfolios.
• Investors buy more seasonal shares (retail, airlines, etc) in anticipation of a Christmas boost to earnings in the next quarter.
• Bargain hunting for cheap shares for the next year's portfolio.
• Fund managers rebalancing their portfolios. Often managers would dump shares that aren't working and reinvest in shares that are working for them.
• Investing Christmas bonuses.

Of course, it could just be a self-fulfilling prophecy. As many people know about the Santa rally, if they see markets moving higher they believe it is working and will also start buying. So, it could all be down to mass psychology of the market.

As we know, there is a tendency for stock market indexes to rise at the end of the year, but not a certainty it's important we use other tools to aid in our trading decisions. This could be using technical analysis tools such as price action and support and resistance levels.

According to the Stock Trader's Almanac, the Santa Claus rally has yielded positive returns in 34 out of 44 holiday seasons between 1969 and 2013. This phenomenon usually happens in the last five trading days of the year and the first two trading days after New Year's Eve. The average cumulative return over these days is 1.6%, and the returns are positive in each of the nine days of the rally, on the average. Nevertheless, each year there is at least one day of declines.

I personally think it happens due to the so-called January Effect, as retailers would normally do better due to the Christmas and New Year sales. There are more reasons to it:

• Holiday optimism;
• Inflation;
• Profit taking;

Holiday Optimism

Holiday optimism is indirectly connected to unemployment. To understand it better, we need to draw a parallel between the unemployment/participation rate and consumer spending. Generally speaking, the participation rate going up is good for the economy. It means more workforce. The participation rate equals a percentage of people of a working age group that are actively employed or looking for work.

Source: Tradingeconomics.com – US Bureau of Labor Statistics

The chart above shows us that the participation has been steady in 2017 with minor ups and downs. A larger participation rate equals more people being employed, which results in more consumer spending. Consumer spending is the largest part of aggregate demand at the macroeconomic level, and it represents acquisition of goods and services by individuals or families. Consumer spending generally rises during the holiday season, as people tend to spend more, which can also boost the stock market.

Inflation

A rise in the stock markets and equities is reflected in inflation. You might be wondering why we need inflation. Inflation is needed for equities to climb even higher. Basically, inflation means that goods and services are being priced higher. Conversely, it provides more revenue for companies, but on the flip-side, it can mean more costs for companies, too. The CPI (Consumer Price Index) is a great gauge of inflation, and US inflation surged again after the hurricane season boosted gas prices. The consumer price index rose in both September and October, being the largest in several months.

Profit Taking

Investors tend to take some profits before the holiday season. It means that the stock markets are subject to a seasonal effect, where they usually take their profits before the holiday season. Remember that each close of a sell position is an automatic buy in the market. If the majority of big investors pull out the money from the markets, it will spike up the price. Don't forget that share prices often follow a seasonal trend at the same time of the week, month, or year as a certain number of traders in the market declines and expands. Additionally, the technical analysis makes it likely that those historical patterns are repeated and aligned with the now moment.

How can we trade the Santa rally?

There are many ways traders can take advantage of these seasonal tendencies. Let's look at one possible way using the FTSE100.

Source: Admiral Markets MT5 Supreme Edition FTSE100, Daily - Data range: from 20 March 2017 - 18 October 2018 - performed on 4 December 2018 at 11:46 AM GMT

As you can see from the chart above, the FTSE 100 has been moving sideways, with big swings up and down for much of 2017 and 2018. However, we know there are some statistics we could use to our advantage, such as the fact the market has risen 83.3% of the time in December. It's not a certainty, but it is an edge.

Now let's look at December 2017 more closely.

Source: Admiral Markets MT5 Supreme Edition FTSE100, Daily - Data range: from 3 August 2017 - 9 May 2018 - performed on 4 December 2018 at 11:49 AM GMT

We can see that December 2017 did rally higher. Traders could have used simple price action patterns to trade off such as the engulfing chart pattern on 15 December 2017. This pattern is where one trading bar totally engulfs the previous day's trading range by penetrating the high and low.

Source: Admiral Markets MT5 Supreme Edition FTSE100, Daily - Data range: from 11 October 2017 - 27 February 2018 - performed on 4 December 2018 at 11:54 AM GMT

A possible entry could be on the break of the high of the bullish engulfing bar, at 7503, with a stop loss at the low of the bar, at 7431. If the trade triggered the entry and then hit the stop loss this would result in a 72 point loss which at 10 lots is a £720 loss. If the trade was closed at the end of the month, at 7698, it would have resulted in a profit of £1,950.

With December underway, how will you be trading stock market indices this month?

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