Around this time every year, optimism in the market starts to rise as investors look forward to a strong finish to the trading year. One of the reasons for this is a peculiar seasonal trend called the Santa Claus Rally. The central premise of this phenomenon is that December is believed to be a strong month for equities, giving way to a market rally. 

When this theory was first penned by a leading trading publication in 1972, the emphasis was on the performance of the S&P 500 index in the US. It focused on the final five trading days of the year and the first two trading days of the New Year. 

Nowadays, however, analysts have become more liberal with their interpretation of the trend. The Santa Rally is increasingly understood to include performance across the entire month of December in markets all over the world. With this in mind, let look at how reliable the Santa Rally has been, and whether it holds true for the ASX.

What does history show?

Since 1950, share market returns during December have been the strongest of any month, with the ASX All Ordinaries gaining an average of 2.1%. While the stocks that have benefitted from this trend vary from one year to the next, the overall picture points to a trend where the ASX has risen in 74% of instances during December. Some Australian broker analysts point to specific periods of strength during December. For example, in the period between 1980 and 2016, 31 of 37 years saw ASX shares advance in December, with market gains averaging 4.2% across each of the 31 positive years. Similarly, between 1980 and 2015, the All Ordinaries has increased 83% of the time in the eight trading days ahead of New Year Eve. If we consider global markets, which often act as a lead indicator for Australian shares, then the trend is compelling. Over the last three decades, global markets have risen 79% of the time in December “ a number quite similar to that of the ASX. As an illustration of how strong this trend is, the next-best results are April, up 74.3% of the time, and then October, which has increased in 68.6% of instances.Across the same timeframe, the magnitude of worldwide gains during December outpace all other months. The average increase in global markets for December is 2.1%, equivalent to the ASX, and leading April (1.9%) and July (1.3%). [caption id="attachment_2469" align="aligncenter" width="601"]

Performance of global markets by month. Source: Schroders[/caption]

Why does the Santa Claus Rally occur?

Although there are no official' reasons for the Santa Rally, observers have long sought to attribute it to a range of potential catalysts. 

The most prominent explanation is the composition of market participants in late December. Typically at this time of year, many institutional traders take their holidays and refrain from active trading. Not only does this ensure that there is a reduction in late-year trading volume, but it generally means there are fewer short trades. On the other hand, retail investors who typically hold a bullish outlook may be rebalancing their trading accounts, or they may be a beneficiary of additional income. Some individuals receive an end-of-year bonus around this time. Many investors also receive dividend proceeds from three of the Big Four banks during December. In both cases, investors may look to invest surplus funds into the stock market amid a positive outlook for the year ahead.It should also be noted that the Santa Rally is primarily derived from the US stock market, where taxation consequences are also thought to act as a driver for share prices. Meanwhile, Australian investors may receive exposure to the rally through strong offshore leads from the US market. In some respects, this seasonal phenomenon has almost become a self-fulfilling prophecy.

Will the Santa Claus Rally play out again?

The Santa Rally represents one of the most consistent seasonal trends in the stock market. Investors who have leveraged this phenomenon have given themselves an upper hand in terms of achieving the sort of returns that history shows are less common at other times of the year. 

However, it is important to realise that past performance should not be viewed as a guide to future market performance. Nothing is certain in the stock market, and a trend will only be true for as long as the market decides to respect it.

All said and done, trying to time the market based on a historical phenomenon is a dubious strategy. While it may hold true across a long timeline, attempting to predict near-term movements in the stock market comes with great risk to investors who haven't done their own homework.