US stock markets are headed for the first year of decline since 2015. This might still be saved by a Santa Claus rally and the corresponding effects that it would have on currency markets, but, will the rally happen? Certainly there are a lot who hope it will so let’s go over some of the factors involved.
What is the Santa Claus rally?
Firstly, although it’s mostly associated with the US, it’s not a uniquely American thing. The FTSE 100 has risen around 80% of the time for its own version, with an average gain of 2.3%. The S&P 500 usually posts somewhat more modest average gains of 1.3%.
There is no official definition for the phenomenon, but broadly speaking it starts about five trading days before the end of the year, and includes the first two days of the new year.
The reason it happens is simply technical: it is an anticipation of the January effect where additional funds are injected in the market for the year. It also happens for tax balancing reasons, such as the fact that certain trades need to be made by the end of the year.
Also, fund managers will switch to stocks that performed well so they can have them in their portfolio at the end of the year just to look good. Call it hedge fund make up if you like.
Sometimes people call it the “December effect,” but that name just isn’t jolly enough for the season.
Why are we talking about it now?
Normally, the Santa Claus rally is just something that happens to the markets in the course of the broader trends. However, due to the underperformance of the major indices in the US since October, all the gains for the year have been wiped off the books.
Nevertheless, there is still a chance that the Santa Rally will be just about strong enough to push them over the line into the green. That’s the case for the S&P 500 and DJIA, while the NASDAQ 100 might have barely closed in the green on its own without the rally.
Away from the US, the FTSE 100 is too far gone on the bear side to be recoverable, even with the most generous Father Christmas. In fact, not only is the FTSE 100 down for the year, it has managed to wipe out the entire gains of this century, closing below the opening on January 2, 2000.
The DAX has also severely underperformed during the year and is beyond saving from a portly man in a red suit; it’s down nearly 20% from its January highs. But this is merely a reflection of Europe-wide stock woes, with the Stoxx 600 down 15% from the year’s high.
All this to say, where possible, a Santa rally would be most welcome for people in the stock market.
But what about currencies?
Glad you asked!
Although the rally is bureaucratic in nature (that is, it isn’t responding to a change in the fundamental values of the underlying assets), it tends to mimic a risk-on environment. In fact, most risk-off traders have primarily taken their position for the holidays and are out of the market, generally speaking.
So, you get the usual risk-on movements in currencies, such as a weakening in the Yen, Dollar, and Swissie, while emerging markets currencies get a bit of a boost. However, this happens during a period of relatively little fundamental news with major traders away from the market, so there is also the issue of lower liquidity in general.
While, on average, stock markets generally rise at the end of the year, this is not always the case and can go in the opposite direction during periods of economic stress. 2014 and 2015 both saw the Grinch take over, with markets averaging over a 2% drop.