Of Santa rallies, January indicators and election cycles

By Jason Chow
Globe Investor Magazine Online, December 28, 2007

If only there was a magic bullet to time the market. Of course there isn't, yet investors somtimes still want to believe there is.

That's when they turn to silly-sounding theories, from watching hemlines on skirts (the shorter, the more bullish) to following the seasons (sell in May and go away until October, at which point you jump back in) to basing investment decisions on the winner of the Superbowl (NFC champ good, AFC winner bad). Basing investment decisions on arbitrary rules feels more like superstition than hard-headed thinking.

But as we approach the end of one year and the beginning of another, there are a handful of market-timing indicators that seem to always creep up and to some, these next few days are the most crucial in determining which way the market will go for the year.

The first rule to consider is the Santa Claus Rally.

Stock markets typically rise during the final five trading days of the year and the first two of the next as the charitable mood of the holiday spills over to markets.

According to the Stock Trader's Almanac, the Standard & Poor's 500 index has risen an average of 1.6 per cent during this period since 1969.

The Almanac goes a step further, saying that Santa's presence is an omen for things to come: "Santa's failure to show tends to precede bear markets, or times stocks could be purchased later in the year at much lower prices." The Santa Claus Rally spills into the First Five Days of January indicator, which, in turn is related to the more popular January indicator. The First Five Days of January rule states that if the markets are in an upswing after the first trading days of the year, then the rest of the year will do well. The January indicator is a more patient version of the same thesis: If the first month is up, the rest of the year will do well.

John McGinley, the retired editor of Technical Trends newsletter, is a rare devotee of the five-day rule. "We're the keepers of the First Five Day flame," he said from Wilton, Conn. "We found that the first five days, being up, you had an extraordinarily accurate record." Since 1942, the rule has been correctly predicting the outcome of the S&P 500 index industrial average 47 times and wrong on only seven occasions.

Mr. McGinley respects the more popular and patient month-long January indicator, but he says the first five days are a faster and more reliable indicator. If you wait for the whole month, you may be missing on three weeks of gains, he says.

His explanation for why the five-day rule works: "In the new year, people often buy back into stocks after they've sold off whatever they've sold to register the tax loss for the end of the year. Then, there's also tons of dividend and bond coupons that pay out in the first of year. There's a lot of money sloshing around. And if the investors use that money to buy stocks, that means they're bullish."

What about the times it's wrong? Mr. McGinley says that's usually because a major bull market tops out at the beginning of the year, then turns south. He warns that 2008 may be one of those anomaly years.

"Say to yourself, if it's terribly late in the bull market, is the likelihood of a recession around us? "You might want to ignore the indicator this time. I think we're in a recession as we speak and the markets have never ignored one. This could be a possible error year even if the first five days are up."

But to others, the five-day rule and the January indicator are both correlative hogwash. What 2008 brings, they argue, is the all-important U.S. presidential election. There are different interpretations on the election theory of market timing but the general rule goes like this: Stock markets perform the worst in the year following an election and continually improve until the next vote.

"The presidential cycle is not goofy," said George Vasic, strategist at UBS Securities Canada in Toronto. "The President want a good economy going into the election and the Fed usually stands by so it's not a factor in the outcome. The cycle works for me."

In the past, markets have done well in election years with the S&P 500 index up an average 8.6 per cent during those periods. Even Standard & Poor's own strategists think the market will confirm the trend: They're predicting the index to rise to 1,650 by the year-end, or a 12-per-cent rise from current levels. And in a recent report, they admitted their adherence to the theory. The forecast, they wrote, is "based on many factors, including the presidential election cycle."

Special to the Globe and Mail