If you’ve been trading index futures long enough, you probably noticed most Octobers that the market tends to shift into high gear, rallying through the middle of January. Although this doesn’t happen every year, it happens enough for it to have earned a few different “seasonality” monikers: the lesser known “Free Lunch” Effect, the Santa Claus Rally, and the January Effect.
Sometimes, all three combine to create a strong end-of-year and beginning-of-year rally. Sometimes just one or two will occur. And every now and then, you might get nothing, except a proverbial lump of coal, not worth the physical commodity’s spot price (currently $65.45 per ton according to Business Insider…now that would be cool!).
What Drives These Three Holiday Rallies?
Despite their designations, especially the one attributed to Santa Claus, there’s nothing magical behind any of them. Price rallies and busts are all about buying and selling; supply and demand. So, apparently, if these three are considered seasonal at all, then something fundamental must be driving them.
Let’s break down each rally and try to explain why they happen, when they typically happen, and you can do the rest, speculating whether Saint Nick or Frosty will bring the market anything worthy of anticipation this holiday season.
The Free Lunch Effect
This not-so-well-known market phenomenon typically begins anywhere from October through November.
The Free Lunch effect is an upcycle that has become consistent enough to have been given a name–though, as you know, there’s no such thing as a free lunch; but it can sure feel like it if you’re able to ride the trend when it happens.
So, what drives it? To take advantage of tax-loss harvesting, investors start unloading their losing stocks toward the end of the fourth quarter. Heavy selling tends to push prices down. Now, if any of the stocks are considered undervalued, investors who didn’t own them may be attracted to their “bargain basement” prices, starting an accumulation process that can continue well into the next year.
The Santa Claus Rally
The Santa Claus Rally typically begins in the last week of December leading up to the new year. Like the Free Lunch Effect, this rally is partly caused by investors looking to let go of losing stocks and bargain investors scooping up what they think might be undervalued.
Another factor that might help in this short-term accumulation phase is that fund managers are spending time with their families–in short, not at their desks to “short” any of investors’ positions. Think of it as Scrooge on vacation. And since enough investors believe that Santa Claus just might come by, many are likely taking speculative bets on the markets just in case. This can sometimes cause a self-fulfilling prophecy, particularly to those who believe in Santa Claus.
The January Effect
What’s one thing that every person does at the New Year (hint: most don’t fulfill them)? If you guessed, New Year’s resolutions, you guessed right. In terms of investments, that often means rebalancing one’s stock mix. Now, the important thing to understand here is that retail investors aren’t the only ones looking to get a new head start for the year. Fund managers are doing the same. Hence, you sometimes get a huge surge in buying volume at the beginning of the year–the January Effect.
Plus, factor in that many investors probably got a nice bonus from work, and they look to make that bonus work for them (unless they have to pay down debt from all of the holiday presents).
So, Are These Seasonal Factors Reliable?
Well, they tend to be consistent, but that doesn’t predict any future market outcome. Remember: past performance doesn’t necessarily indicate future results (sound familiar?). So, what might you do?
If you’re an investor, this shouldn’t change your long-term strategy of dollar cost averaging and occasional rebalancing. If you’re looking for bargain buys, then wouldn’t you buy them regardless of the season?
If you’re an index trader, then you might want to anticipate the possibility that such a thing might occur. Of course, your approach likely accommodates such an opportunity should it arise. So the important thing is just to remember that it “tends” to happen, and that if it does, hopefully you’ll be able to take advantage of it.
The Bottom Line
Seasonal patterns aren’t inexplicable; this much you should know. They’re driven by large purchases and sales. What’s important for you, as a trader, is to understand the reasons behind such occurrences, and when to expect them (should they materialize). Even if these opportunities don’t pan out, they’re consistent enough to carefully anticipate (especially if, for whatever reason, you’re looking to go short). It’s better to be prepared than to get hit by a free lunch item, trampled under hoof by Santa Claus’ reindeer, or charged by a bolting Frosty as we start the New Year.
Please be aware that the content of this blog is based upon the opinions and research of GFF Brokers and its staff and should not be treated as trade recommendations. There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.