Christmas is just around the corner, and if you’re like many investors, then you likely have a year-end rally on your wish list.  If this is you, then you’re probably in luck because history has shown that a so-called Santa Claus rally could be in the making in the weeks ahead. 

Make no mistake, after this year’s bout of market volatility, many investors are looking for hopeful signs that their savings and retirement balances will once again be on the rise heading into the new year.  And history has shown that over the past few decades that Santa, more often than not, has brought cheer to the good little boys and girls on Wall Street in the final few days of the year.  

How do we know this?

Well, looking at data going back over forty years, our work suggests that the S&P 500 Index has gained an average of 1.0% in the six days following the Christmas holiday and into the first few days of the new year.  And what’s more, in the years where the markets have had negative year-to-date performance, like we’re experiencing this year, the markets tend to rally an average of 1.5% in just a few short days.

So, the question on many investors’ minds now is, “is the Santa Claus rally possible, and will it pave the way for a broader rally next year?”

The short answer to this question is yes… but… 

History has indeed shown that positive annual market gains have followed a sustained Santa Claus rally in down years.  However, 2022 has not been your typical year by any stretch of the imagination.  And while a bull market could be in the making for the coming year, several factors suggest that we’re likely to experience bouts of heightened volatility before markets finally transition to a rally.

What’s Supporting Sentiment Now?

The good news is that market sentiment appears to be showing signs of improvements at the margins, which has been evident in higher prices among many parts of the US and global equity markets over the past six weeks. 

Amidst all these market moves, what’s essential to understand is that the Federal Reserve has been a critical driver of market sentiment this year.  In its bid to quell double-digit inflation, the central bank committed to an aggressive policy response, raising rates six times since March and to their highest level since 2007.  Markets responded to this development by selling off sharply in anticipation of an economic and earnings recession.

Overall, however, the economic slowdown that had been predicted didn’t quite play out as many market watchers had anticipated.  And by many measures, US firms have adapted to rising input prices and slowing demand, ultimately allowing corporations to avoid the deep earnings recession that had been predicted just months ago. 

What’s more, heading into this year, many corporations demonstrated discipline with their cash reserves, while households have generally felt confident enough to spend freely despite signs of growing stress in the overall economy. 

As a result, many investors have taken these signs of economic resilience as an indication that maybe financial conditions aren’t as bad as what was priced-in earlier this year.

And this point is essential because some investors believe that if the economy is in a better position to weather higher interest rates, then when the Fed eventually stops raising rates, the economy, corporate earnings, and the markets could bounce back sooner than expected. 

Things Likely Will Get Worse Before They Get Better

While there’s no doubt that growth has been more resilient than expected, incoming data for the fourth quarter suggest that the economy could be headed for another leg lower.

And this trend is likely to be exacerbated by the fact that it takes time for the effects of higher interest rates to make their way through the economy at large. 

For example, even if the Fed announced no further rate hikes tomorrow, the US economy likely would continue to slow for months to come. 

And from this perspective, corporate earnings will likely face headwinds in the coming quarters as data reflect depleted consumer purchasing power, evident in declining household savings and rising credit card utilization.  In anticipation of this slowdown, firms are increasingly reporting plans to let go of workers, which could set in motion a negative feedback loop for the economy.

Rising interest rates have already impacted consumers, evident in declining housing affordability and purchases of big-ticket items like automobiles.  And while many corporations are holding onto high levels of cash on their balance sheets, those that actively borrow in the credit markets to fund operations likely will see more of their operating cash flows diverted to debt service costs as interest rates remain elevated. 

Barring other factors, we could finally see the strong labor market turn a corner as layoffs and hiring freezes become more widespread throughout the economy. 

This expectation of weaker growth is now baked into consensus expectations for 2023, with many economists once again anticipating an economic contraction in the first and second quarters of 2023.   

Putting it Into Perspective

Given this outlook for a weakening economic environment, it’s likely that market sentiment could decline in the months ahead.  Indeed, the critical market narrative supporting market optimism among many investors this year has been “the Fed Pivot,” or buying in anticipation that policymakers will eventually stop raising interest rates. 

Even so, Fed officials have been actively voicing their insistence since Powell’s pain remarks in August that little evidence suggests that the Fed is done raising rates anytime soon.  And while we’ve seen a market rally in November, it’s entirely possible that what we’re seeing now, and likely to see through year-end, is simply a bear market rally. 

Indeed, in 2008, large-cap stocks rallied 27% between November lows and early January 2009 before markets capitulated, eventually marking the bear market low of March 9, 2009. 

Overall, while some indicators suggest that a market bottom could be in the making now, like the recent bull-bear spread trend in investor sentiment, or put call ratios, market participants today are navigating largely uncharted territory. 

Don’t Be Fooled by the Santa Claus Rally

Putting it all into perspective, the Santa Claus rally would be a welcome development after this year’s market disappointment.  Even so, one would be wise to approach any year-end rally with caution. 

To be sure, uncertainties regarding the current economic outlook coupled with looming geopolitical uncertainties in Ukraine and China suggest that we may be looking at more volatility in the first half of 2023. 

And while economic data is currently in decline today, policymakers likely will wait until they see “pain” in labor market data and declining inflation expectations before indicating that they could change their stance on monetary policy.

This holiday season, don’t be fooled by a Santa Claus rally.  While it may be tempting to jump on board the year-end rally should it arrive, conditions are prime for disappointment as we likely headed for a fresh bout of market volatility in the weeks ahead.

That’s why a disciplined risk management approach and an eye for opportunity likely are sensible approaches as we look ahead to the start of 2023.  Indeed, we recommend avoiding taking excess risk in the markets, and using recent rallies to rebalance to target asset allocation levels. 

We’d also suggest keeping higher cash levels on hand to weather prolonged market selloffs and avoid selling securities at inopportune times as a way to preserve your path to financial independence.