Stock market forecasters better watch out for the Santa Claus rally

Stock markets around the world were down on their first trading day of 2016 — not a good portent for the year ahead.

Many market strategists look at seasonal factors to help forecast stock market performance, and some of them have a very good track record.

Several indicators centre on the changing of the calendar year, including what's known as the Santa Claus rally. 

We'll get to that, but let's start with a look at another forecasting favourite.

How the presidential cycle affects the stock market

U.S. presidents get elected every four years in November and, since 1933, take office in January. Because of the pattern of electoral politics, strategists anticipate that certain things will happen in certain years.

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Sam Stovall, the influential equity strategist at S&P Capital IQ, says that U.S. stock markets usually do better in the third year of a presidential term. "The market expects the party in power to try to stimulate the economy so that the stimulus will bear fruit by the time the voters go back to the polls," he says.

Then investors "buy in, expecting this stimulus to do its magic."

Stovall is the author of The Seven Rules of Wall Street: Crash-Tested Investment Strategies That Beat the Market, published in 2009.

Since 1945, the Standard and Poor's 500 index of U.S. stocks has had an average annual gain of 8.8 per cent, but in the third year of the presidential term, the average gain was 16.1 per cent.

During Barack Obama's presidency, however, third years did not follow the pattern. Stovall says that's because in 2011 there was a reduction of stimulus due to conflict between Obama and the Republican House of Representatives, and last year Obama didn't offer anything to a hostile Republican Congress that could have become stimulative.

Stovall also points to the significant difference in performance when comparing first and second terms during an eight-year presidency.

Jeffrey Hirsch, editor of the Stock Trader's Almanac, notes that 2015 was the first time since 1939, the year the Second World War started, that the Dow Jones industrial average was down in the seventh year of a presidency. Over 1940 and 1941, the Dow fell by about one-third.

Hirsch also points out that in years like 2016 (the final year of a two-term presidency), the Dow averages a drop of 13.9 per cent, and the index has been down in these cases five of the last six times.

No Santa Claus rally?

There's been lots of talk in the business press in recent days about the Santa Claus rally. Definitions vary, but since the term was coined by the founder of the Stock Trader's Almanac, Yale Hirsch (Jeffrey's father), we'll use his benchmark. It looks at the overall performance of the last five trading days of a year, plus the first two trading days in the new year.

This year's result will be known when markets close today, but it's not looking like a rally. 

For a rally to materialize, the S&P 500 needs to surpass its Dec. 23 close of 2,064.29. The index's closing price on Monday was almost 52 points away, 2,012.66. On only one day in the last four years has the index risen more than 52 points.

Jeffrey Hirsch told CBC News the seven-day trading stretch is usually positive for stock markets because tax-loss selling has ended for the year, funds are busy with year-end padding of portfolios and the people still trading stocks during those days are "mostly professionals buying beaten-down stocks, so when you don't have that rally there, it's an indication that the pros are not really enamoured with the outlook for the market, and that's a negative indicator for the future."

His father coined the legendary saying, "If Santa Claus should fail to call, bears may come to Broad and Wall." And the last four times the Santa Claus rally was negative, Jeffrey Hirsch points out, Wall Street's year would go on to be either flat or have a bear market.

More seasonal indicators ahead

The December low indicator dates back to the 1970s and market analyst Lucien Hooper. It compares the closing low for the Dow in December (17128.55 on Dec. 18) to the daily closing lows during the first quarter of the next year. Hooper said, "If that low is violated during the first quarter of the new year, watch out!"

That would have happened on Monday, except the index went up above the December low in the final few minutes of trading, surpassing it by 20 points. It could still happen anytime in the next three months.

Other analysts look to the stock market performance during the first five trading days of the year as a predictor of the year ahead. Also, many traders quote another line of Yale Hirsch's: "As goes the month of January, so goes the year."

Jeffrey Hirsch advises investors to look at the three January indicators and the December low together. If they are all negative, "it's quite a negative."

Stovall points to what we'll call the January-February barometer. For this seasonal trend, he looks at the S&P 500's performance in both January and February. Since the end of the Second World War, in 26 of those years the index was up in both January and in February. At the end of all of those 26 years, the index was up for the year, with an average total return of 24 per cent.

Looking at just the last 10 months of those 26 years, the index was up 24 times, with an average total return of 13 per cent.

The index has been up in 80 per cent of the years since 1945, but a track record of 100 per cent for the January-February barometer is still amazing, Stovall says. 

Seasonal and cyclical factors are just one dimension Stovall and Hirsch use to come up with a market strategy. Of course they look at other rather weighty matters, starting with the economy.