Don’t fall for the ‘Santa Claus rally’

Bloomberg

Do you believe in Santa Claus?

Wall Street does — or at least is hoping that you do. Every year around this time, many analysts and brokers begin referring to a "Santa Claus rally" that will propel the market higher.

Don't fall for the sales pitch. The stock market's average performance before Christmas is no better than mediocre. It is only in the last week of December that the market has strong seasonal winds blowing in its sails.

Consider the stock market's gain from Dec. 1 through its highest close during the month. On average, the Dow Jones Industrial Average (DJIA)   is 3.1% higher at that point than where it stood at the beginning of the month, according to a Hulbert Financial Digest study of the Dow since its creation in 1896.

If history repeats itself this December, the Dow will reach 16577, based on Friday's close of 16086.

Click to Play The elephant in the room

Investors too often fail to talk to their families about their finances, say Ken Dychtwald, CEO Age Wave, and David Tyrie, managing director at Bank of America Merrill Lynch. Advisers sometimes need to push them into these conversations.

In fact, though, a 3.1% rally is below average. It turns out that eight other months — from March to July to October — have stronger rallies than December when their performance is measured the same way. The average Dow rally in all non-December months is 3.4%. So the market's rally potential prior to Christmas is below average.

You didn't really believe in Santa Claus, did you?

Not all experts who refer to a Santa Claus rally equate it with how much the market rises through its December high, though few bother precisely defining what they do mean. But other attempted definitions don't fare much better.

One that has been used over the years by some of the advisers the Hulbert Financial Digest monitors is based on supposed market strength over the entire period between Thanksgiving and Christmas. Yet the average Dow gain over these few weeks is statistically indistinguishable from how it performs at any other time of year.

In other words, you shouldn't let the Christmas season sway you from whatever investment strategy you already were pursuing. For most investors, the best general strategy is buying and holding a broad-based index fund. Among the lowest-cost ways to invest in the U.S. stock market is the Vanguard Total Stock Market exchange-traded fund (VITSX)  , with an annual expense ratio of 0.05%, or $5 per $10,000 invested.

There is one version of the Santa Claus rally that enjoys strong historical support: the last five trading sessions of December and first two of January.

This year, for example, a trader wishing to capture this rally would buy stocks as of the close on Dec. 23 and sell them at the end of the trading session of Jan. 3. Traders have been aware of this particular version of the Santa Claus rally at least since 1972, which is when the editors of the annual Stock Trader's Almanac say they discovered it.

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Since the Dow was created in 1896, it has gained an average of 1.7% during this seven-trading session period, rising 77% of the time. That is far better than the 0.2% average gain of all other seven-trading-session periods of the calendar.

Are these heightened odds of success good enough to justify the transaction costs involved in a specific bet on strength over these seven trading sessions near the turn of the year?

The answer isn't clear — especially after you consider short-term capital-gains taxes, brokerage commissions and "bid-ask spreads," or the gap in price between the price you have to pay when buying a stock and what you get when selling it.

The stocks for which these spreads are the smallest — those with the largest market capitalization, or "large caps" — also are those most likely to be the targets of traders who, by attempting to exploit this seasonal pattern, cause it to weaken.

Norman Fosback, editor of Fosback's Fund Forecaster and former president of the Institute for Econometric Research, says that seasonal patterns in large-cap stocks have "receded in significance" in recent years.

Unfortunately, the smallest-cap stocks for which seasonal patterns remain the strongest also tend to have the highest bid-ask spreads.

These "microcap" stocks — a loosely defined category that contains issues that are even smaller than the small caps—tend to range in size between $100 million or so and $1 billion in total market value.

Fosback nevertheless favors the microcap category for the seasonal portfolio he recommends to clients, though not by buying and selling individual stocks. Instead, he prefers the iShares Micro-Cap ETF (IWC)  , with an expense ratio of 0.72%. The fund replicates the performance of the smallest 1,000 stocks in the Russell 2000 Index (RUT)  ; the average market cap of the stocks it owns is $420 million.

Even though the individual stocks the ETF owns typically trade with wide bid-ask spreads, the fund doesn't; over the last three months, for example, its average spread has been just 0.1%.

Another fund that focuses on even smaller stocks is the Wilshire Micro-Cap ETF (WMCR)  , with a 0.58% expense ratio. Though the average market cap of the stocks it currently owns, at $252 million, is smaller than that of the iShares Micro-Cap ETF (IWC)  , its average bid-asked spread tends to be larger — 0.6% over the last three months.