Chasing the Santa Claus Rally: December Trends in US Equity Indices

If we can identify consistent repetition, it can offer edge in trading.

Naturally, that edge is diminished if everyone is looking at the same thing, and in a world of increasing advancements in AI, if there is an edge to be had through repetition it will unlikely be the manual and discretionary trader who exploits it.

One aspect of repetition in markets which comes up every year as we approach December – that can be traded by all market participants - is the idea of a “Santa Claus” rally in US equity indices and a positive expectancy and predictability of equity returns.

With the S&P500 (the most tracked US equity benchmark) having such a blistering year, we consider if the impressive 23.5% YTD performance increases the prospect of a strong seasonal rally through December. Or is the so-called “Santa Claus” rally just a market saying thrown around, with limited statistical relevance?

Chasing returns – Beating a benchmark

Assessing the performance and the seasonal form of the S&P500, NAS100 or Dow in December is complicated. We’re reviewing historical returns on a monthly basis, so essentially, we need at least 20 years of monthly returns to consider the sample statistically significant.

However, the capital markets have evolved so radically over the past 20 years, with incredible technological advancements and the rise of algorithmic trading that accounts for about 80% of the daily S&P500 volume. New players and an increased frequency and speed of execution make contrasting how markets fared in 2004 relative to the assumption of what could play out in 2024 a tough proposition.

That said, one consideration that hasn’t changed over the past 20 years is the idea that active money managers (e.g. hedge funds and investment managers) must beat benchmark returns to meet their marketed objectives and to get paid their performance fee.

Therefore, should we head into December with the S&P500 and NAS100 pushing to new highs, then regardless of an investment manager's view on valuation, or company fundamentals, if their fund is not easily outperforming the S&P500 (or the equity benchmark they track), then they simply must put capital to work in the equity market and chase the index higher.

If their fund is underperforming the S&P500 they may even need to even dial up the risk.

Reviewing the seasonal performance of US equity in December

Looking at the monthly returns of the S&P500 over the last 20 years, we see that December has on average been a historically strong month, with the S&P500 gaining 0.9% on average.

Steep monthly declines of 5.9% in 2022 and 9.2% in 2018 impacted the 20-year average.

However, if we remove the occurrences of negative monthly returns, in the months the S&P500 closed higher in December, the average gain was an impressive 2.6%.

So when we have seen a positive return in December, they have historically been quite lucrative for longs.

The form guide also shows some consistency in the returns, with the S&P500 closing higher in the month of December in 70% of occurrences and in 4 of the past 5 years.

We can even blend the S&P500 daily returns over the past 20 years into one smoothed chart to help visualise the seasonal trends in returns. We can see that after a degree of selling in early December, the Santa Rally really kicks in (on average) on 20 December.

December equity returns are higher the greater the YTD performance

Again using 20 years of S&P500 monthly returns, we see that in the 10 occurrences (years) where the S&P500 has gained more than 10% through January-November, the average return in December is a healthy 2.2%. However, of these 10 occurrences, 90% of these resulted in a positive return for the S&P500 in December.

Conversely, of the 9 occurrences (years) over the past 20 years where the S&P500 was up by less than 10% through January-November, the average monthly return in December was -0.6%, with the S&P500 closing higher in only 40% of occurrences.

One can then argue that the so-called ‘Santa Claus’ rally is highly conditional on the YTD performance of the S&P500 coming into December. With the odds of it playing out increasing the greater the YTD performance of the S&P500.

The fact that the S&P500 is currently up 23% YTD, suggests a higher probability of a strong December and a chase for performance from those that need to outperform.

US Equity Catalysts and Risks to Consider

Aside from the previously mentioned drivers of potential index returns in December, we can consider other prominent risks to equity, as we do the upside catalysts.

Bullish factors that could drive seasonal upside

• Strength begets strength - The S&P500 has gained an impressive 23% YTD, suggesting that the prospects for an end-of-year performance chase increase.

• Record levels of corporate equity buybacks are suppressing volatility and reducing equity drawdown risk.

• When a sector within the S&P500 gets too hot and overbought, market players are rotating into other areas of the equity market that haven’t participated - active rotation is the sign of a healthy bull market. • US economic growth data continues to improve – while improved economic data reduces the need for the Fed to cut rates, US equity is supported by low recession risk.

• A rebound in the upcoming US nonfarm payrolls report (on 6 December) would be a positive catalyst for US equity indices.

• A lower-than-expected core PCE inflation print (28 Nov) and CPI print (11 Dec) – should it play out - would be a big positive for both the US bond market and by extension the equity too. • A further reduction in S&P500 volatility would see the volatility-targeting funds (insurance, pension funds) increase exposures to US equity.

Potential risks to US equity markets

• We see another poor US nonfarm payrolls (6 Dec) report that increases concerns about the health of the US labour market.

• A higher than consensus US PCE and CPI inflation print would likely be a headwind for equity – the market can absorb reduced rate cut expectations if driven by stronger growth data, but not on higher inflation risk.

• A renewed sell-off in the US 10-year Treasury, with yields rising above 4.60% would be a headwind to risk – especially if inflation expectations also rise.

• We see concerns that US tariff negotiations could be far more protracted and sinister than feared (and what’s priced). Cross-Asset Seasonal Performance Away from US equity indices, we review the form guide for historical December returns (over the past 20 years) and identify repetition and consistent trends in other key markets.

• December is on average the worst month for USD returns, with the USD index (DXY) seeing an average monthly decline of -0.6%. The USD index (DXY) has closed lower in December for 7 consecutive years.

• EURUSD has closed higher in December for 7 consecutive years, as has gold. • AUDUSD has seen positive returns in December for 5 years in a row. • USDJPY has seen negative returns in December in 5 of the past 6 years.

• The German DAX and ASX200 closed higher in December in 66% of occurrences, with both indices seeing an average gain of 1.5%.

A Big December Awaits

So, the stage is set for a big December, and while much rides on the outcome of the marquee US economic data, as it does on the news flow and the sentiment in markets, given the exceptionally strong YTD performance of the S&P500 and NAS100, the backdrop is certainly there for a strong chase into year-end, and the illustrious ‘Santa Claus’ rally.