If Santa Brings Stock Rally, It Could Be Bumpy Ride

If the stock market enjoys a traditional Santa Claus rally this year, it may also come with some tough sledding.

More years than not, the week between Christmas and New Year’s has brought a gift to investors, with stocks posting healthy gains, but given the market’s growing volatility in 2007, even if the Grinch doesn’t steal Christmas, he may steal the show on Wall Street a couple days, when stocks might otherwise be drifting higher.

Nam Y Huh / AP Santa Claus

Depending how you look at, the Santa Claus rally is anything between a week and several weeks long.

Coined in 1972 by market historian Yale Hirsch, who founded the Stock Trader’s Almanac, the Santa rally originally applied to the last five trading days of December and the first two of the New Year.

Lots of Uses

“People use it to refer to any number of rallies that occur in the last quarter of the year,” says Jeffrey Hirsch, who succeeded his father at the Almanac.

That’s partly because November and December – along with January – are the three best months of the year for stocks.

For each of the past 40 years, stocks have posted solid and sometimes spectacular gains between their bottom in November or December and high in December or January.

Between 1968 and the collapse of the tech bubble in 2000, the Dow gained an average of 10.62 percent. Again, the uptrend remained in place during the bear market years that followed an thereafter.

Jim Awad, vice-chairman of JW Stewart Asset Management, is a believer in the Santa Claus phenomenon, explaining that it is an “optimistic and happy time of year and money managers want to finish the year strong.”

Other Factors

Buying is also attributed to tax considerations, investment of year-end bonuses and anticipation of the January effect, another phenomenon in which stocks typically gain during the first month of the year.

On a less debatable level, trading volume is relatively light -- pessimists are on vacation --- and susceptible to an updraft.

Richard Drew / AP Holiday Cheer -- New York Stock Exchange, 2006

“The question this year is whether asset write downs overwhelm this,” says Awad.

At this point, 2007 looks promising, largely because the market hit a post-record high bottom of 12,743 on Nov. 26, qualifying for a 10-percent correction.  Since then the market has rallied some 5 percent.

That’s also an illustration of the heightened volatility in recent months. Of the S&P 500’s 16 sessions with moves of 2-percent or more, fifteen have come since August – and 10 of them have been to the downside. Since 1928, the average is 15.4 moves of that kind per year. The median is nine.

What's more, for the past month, the CBOE's Volatility Index

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[VIX  Loading...      ()   ],or Vix, has posted daily readings over 20, generally thought to represent a volatile stock market. As a rule, high Vix readings occur on days when stocks surge or plunge.

“I'm going to be keeping a closer eye on it this year,” says Hirsch, given the volatility and uncertainly.

Stovall, who warns about “stretching your faith in the mechanical indicators” is nevertheless optimistic about an end-of-year rally this year. That’s partly because the market hit a “lower low” on Nov. 26, surpassing its previous 2007 low set in late August, during the summer meltdown, when stocks plunged from record highs.

“The bears can sometimes have Thanksgiving but the bulls have Christmas,” says Stovall.

Now that’s the spirit.