Kaufman Signals

Will Prices Give Us A Christmas Gift?

Is there a Christmas rally in the stock market? Is there liquidation at the end of the year? So far, our election predictions have been correct, that the day after the election will determine the direction of prices for the next three weeks. We’re now past that. What can we expect for the rest of the year?

If we look at the history of December performance from 1950, shown in Chart 1, we see that December is largely profitable, with only 14 of 66 years posting a loss. While average net gains are relatively small, there are a few big years. Surprisingly, there doesn’t seem to be any relationship between performance from the beginning of the year and the December returns. The correlation for all the years was only 0.20, barely positive. The gains through November this year are a positive sign of continued profits in December, but not a strong indicator.

Chart 1. Returns in December for SPX from 1950.

A Christmas Rally?

Now let’s look at the December returns for more recent years using SPDR ETF, SPY. One of the problems is aligning the data. We’ve decided that we would align the first 10 days, regardless of the day of week, and the last 10 days. In Chart 2, the bottom scale shows “-1” on the far right. That’s the last trading day of the year, regardless of day and regardless of date. The “-2” is the second trading day from the end of the year, and so on. We think this correctly represents the way we see the market.

Chart 2. Average returns for December by day from the beginning and from the end of the month.

Chart 2 is very consistent for the two periods, 1998-2015 and 2011-2015. We can say that Christmas falls about five days before the end of the month which corresponds to the very end of the Christmas rally. Overall, we see December starting with some leftover optimism from Thanksgiving, but that fades after a week and is following by a reversal, perhaps the real liquidation. The Christmas rally is in force a week before Christmas and is strongest eight days before the end of the month.

The pattern through Christmas Day and a few days further seems to parallel how we think of everyone’s psychological mood. Good after Thanksgiving, tired of shopping in the middle of December, positive again going into Christmas week, and tired of everything after Christmas.

End-Of-Year Liquidation and Early January

Enter the reality of 2016 taxes. We did not find any relationship between making money in the first eleven months of the year, and liquidation at the end of the year. It may be there, but it was a more complicated pattern than we were looking for.

It is clear in Chart 2 that gains taper off to become losses in the last few days of the December, but it’s also possible that the end-of-year liquidation occurred midmonth, in days eight through ten, where returns were consistently bad.

Turning to January, Chart 3, we see a rally on the first day. It can’t be resetting of positions liquidated in December because any trade reset within 30 days would be considered a “wash trade” by the IRS. Overall, the beginning of January looks to be ennui after the holidays.

Chart 3. SPY Average returns for the first 10 days of January.

If not January, do traders reset their positions in February, more than 30 days after they’ve liquidated? Chart 4 looks more promising. The pattern for the two periods are similar, but much stronger for the past five years. Returns for February in those five years have been +4.06, +1.10, +4.31, +5.48, and -0.41, clearly very good. We can’t know for certain, but February would be a likely month to reset any positions liquidated in December.

Chart 4. SPY Average returns for February.

The Best Trade

The economy seems to be in good health, and the new administration is perceived as friendly to business. We can accept that as the reason for the November rally. We also think it will continue up to just before Christmas week this year. Both long-term and short-term history support it. We don’t expect anything to happen from Christmas through January, unless there is some substance coming from the new administration with regard to policy and a timeline. But February looks like a good candidate for another move up.

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Perry Kaufman is a financial engineer and trader. He is the author of Trading Systems and Methods, 5th Edition (Wiley), and A Guide to Creating a Successful Algorithmic Trading Strategy (Wiley). For question or comments, please visit his website, www.kaufmansignals.com.

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