Will Santa Claus Deliver a Year-End Rally for Investors?

By Kira Brecht

It turns out Santa Claus doesn't just deliver gifts under the Christmas tree. Traditionally, November and December are positive months for the U.S. stock market as well.

Chalk it up to year-end catch-up buying or positive seasonal holiday cheer, but history shows that investors can expect stock market gains into year-end, particularly because of the trend known as the Santa Claus rally. But this year's wild card is the Federal Reserve, which is considering an interest rate hike in December. Let's take a look at what could lie ahead for Wall Street as well as opportunities for investors now.

What is the Santa Claus rally? The Santa Claus rally phenomenon is a short but respectable upward move in stock prices over the last five trading days of the year and the first two days of the new year -- a trend identified and popularized by Stock Trader's Almanac publisher Yale Hirsch in 1972.

%VIRTUAL-WSSCourseInline-1023%Over this seven-day trading period since 1969, the Standard & Poor's 500 index (^GSPC) has averaged a 1.4 percent gain in the Santa Claus rally. One of the factors driving stocks higher is buying action by portfolio managers who are chasing stock winners and gains in an attempt to "window dress" their portfolios for year-end statements, says Jeffrey Hirsch, Yale Hirsch's son and the current editor at Stock Trader's Almanac.

Significantly, the Santa Claus gains can be used as a warning signal for stock market action ahead. "The significance of the Santa Claus rally is really when it does not occur. If Santa Claus should fail to call, bears may come to Broad and Wall," Hirsch says, referring to the streets. Over the last 21 years, the Santa Claus rally has failed to emerge only four times, which preceded flat overall performance years in 1994 and 2005 and down markets in 2000 and 2008, he says.

October's gains may keep Santa away. Looking at the bigger picture, there is a general seasonal tendency for positive stock market performance in November and December. "Over the last 10 years, on average, the S&P 500 has gained 0.38 percent in November and 1.29 percent in December," says John Canally, investment strategist and economist for Boston-based LPL Financial.

However, Santa Claus and his reindeer may run into some trouble, as this year offers conflicting headwinds for the seasonal bullish performance period. "We had an extraordinarily strong October, and that likely ate into a little of the gains that we normally see in November and December," says Hank Smith, chief investment officer, at Philadelphia area-based Haverford Trust.

Analysts point to the Federal Reserve as a potential spoiler for the traditional Santa Claus rally action. Smith highlighted the widespread uncertainty over how the stock market might react to a Federal Revere rate hike. "Assuming we get a rate hike in December, we might be looking at markets that trade relatively flat between now and year-end," Smith says.

The Fed is widely expected to raise interest rates at its December meeting, which would mark the first increase since before the global financial crisis began in 2008. Analysts will be watching closely for clues on how far and how fast the central bank might raise rates in 2016, and this could be the key to the stock market's reaction, Canally says. "If the Fed raises rates in December and says we will only do three or four more hikes next year -- in that environment, we will get the Santa Claus rally," Canally says.

For active investors looking to jump on seasonal trends, another well-documented phenomenon is the January effect, in which small-capitalization stocks tend to outperform large-cap stocks. But investors should take note: The January effect has been occurring earlier in recent years. "Nowadays, most of this so-called January effect takes place in the last two weeks of December. This is likely due to the anticipators trying to take advantage of this trend and getting in earlier," Hirsch says.

"Small caps and beaten-down bargain stocks should be positioned to rally again this year in late December. If the market reacts positively to whatever the Fed does on Dec. 16, that would be a bullish sign for the small-cap effect and the Santa Claus rally," Hirsch says. There are several exchange-traded funds that track small-cap stocks, including iShares Russell 2000 (IWM).

Kira Brecht is a financial journalist who writes extensively on stock, commodity, and foreign exchange markets, investing strategies, the economy and the Fed. She was managing editor at SFO (Stock, Futures & Options) Magazine for 10 years, creating digital magazine, newsletter and online content aimed at the individual investor. She began her career on the floor of the Chicago futures exchanges covering commodity markets for a financial newswire service. Follow her on Twitter @KiraBrecht.