VERSACE: What does Santa have for the stock market?

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OPINION/ANALYSIS:

As I write this, there are 10 trading days left before the Christmas holiday and 14 before the end of 2009. With only so many days left and the market, as measured by the S&P 500, up 21.8 percent for the year so far (and up 38 percent from its March lows), many have been wondering exactly how much steam is left in the stock market engine.

Good question, especially with the S&P 500 trading at 14.8 times the figure of 2010 expected earnings - $74.24. I would point out that level of expected earnings implies year-on-year growth of 27 percent over 2009, which more than a few, including myself, view as aggressive. Alongside the notion of holiday shopping, caroling and mistletoe, investors turn their eye to look for signs as to whether or not a “Santa Claus rally” in the stock market is upon us.

For those unfamiliar with the term, a Santa Claus rally is a rise in stock prices in December, generally seen in the final week of trading prior to the new year. Per published data from InvesTech, over the past 40 years, the average gain from Nov. 20 through the end of January has been 4.2 percent, or an annual rate of 23 percent. Looking further back in the data and putting the entire 80 years of S&P 500 data for that year-end period under the microscope, only two of those 80 years experienced a decline of greater than 10 percent: 1931 and 1969.

Again, that 4.2 percent gain has been the average, so in addition to looking at the worst years, it’s only fair to look at what the higher end of the returns have been in the past 80 years. Ten Santa Claus rallies in the past 80 years produced gains in excess of 10 percent.

There are several theories as to why a Santa Claus rally occurs, and they range from people being flush with cash from bonus payments to festive moods owing to holiday cheer and year-end prognostications for a better new year.

Another theory reflects investor “window dressing.” Window dressing, simply put, is a strategy used by professional investors (read that as “mutual fund and portfolio managers”) near the year’s or quarter’s end to improve the appearance of their portfolio performance, because their performance reports (report cards, if you will) and a list of portfolio holdings tend to be shared with clients on a quarterly basis.

Some fund managers or investors publishing their performance report will sell stocks with large losses and purchase stocks that are performing well near the end of the quarter so as to include them on their report card to their clients.

There are others that support the notion that the Santa Claus rally flows into the January effect, which is a calendar-related anomaly in which stocks and other financial security prices increase in the month of January.

Donald Keim, a professor of finance at the University of Pennsylvania’s Wharton School, first observed this anomaly in the early 1980s when he was a graduate student at the University of Chicago. At the time of his observation, small stocks had outperformed the broader market in nearly every January since 1925. The most common theory explaining this phenomenon is that individual investors, who are income tax-sensitive and who disproportionately hold small stocks, sell stocks for tax reasons at year’s end and reinvest after the first of the year.

To be fair, much like there are highs, lows and no-shows for the Santa Claus rally, the same is true for the January effect, as small-cap stocks didn’t do as well as large stocks in 1982, 1987, 1989, 1990 and 2008.

There is, of course, no guarantee that Santa will deliver this year. What are some of the signs I’m looking for to see whether old St. Nick will appear? There are the obvious issues weighing in on the stock market that could damp down the Santa effect this year - the health care debate, the weak dollar, how robust the underlying economy truly is and the prospects for sustainable job creation.

Another factor that could put a crimp in the holiday rally is the stock market’s nearly 22 percent rise for the year itself. After a rocky ride since October 2007, odds are money managers are anxious to lock in their performance. According to data published by the Investment Company Institute, total net new cash flow into equity funds have fallen by $9 billion for the five weeks ending Dec. 2, while bond fund net new cash flow has risen by $44.3 billion over the same period. This, combined with investors flocking to Treasuries in recent weeks, supports the thought that although Santa may come this year, he may not be as jolly as in previous years.

• Chris Versace is director of research at Think 20/20 LLC, an independent research and corporate access firm based in Reston. He can be reached at cversace@washingtontimes.com. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.

About the Author
Chris Versace

Chris Versace

Chris Versace, the “Thematic Investor,” is the director of research at Think 20/20, an independent equity research and corporate access firm located in the Washington, D.C. area. Before Think 20/20, Mr. Versace was the portfolio manager of Agile Capital Management (ACM), a thematically driven alternative investment fund. The groundwork for ACM was laid during Mr. Versace’s tenure as senior vice president of equity ...

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