Corrections, seasonality and the Santa Clause rally

"Is a correction immintent?" asks market historian and money manager Jim Stack, who anwers," "Yes. But one could answer that question the same way at almost any stage of every bull market in history."

In his Investech Market Analyst, he looks at the market's history to help forecast both the likelihood of an upcoming correction as well as the historical evidence for a "Santa Claus rally".

"The real question to ask is when and how severe the next market correction will be. On average, a 5% correction comes around every 5.8 months in a bull market.

"So the fact that we’ve already had 3 such corrections in 8 months proves that this bull market is anything but 'correctionless' as some will claim.  Indeed, we believe that corrections are a healthy characteristic in a bull market.

"Larger corrections, of 10% or greater magnitude, are far more rare.  However, every bull market since 1929 has experienced at least one 10% correction before hitting the final bull market high and entering a bear market.

"On average, a 10% correction occurs only once every 29 months (yes, that’s less frequent than one in two years). So the fact that we’ve gone 8 months without a 10% correction could hardly be called abnormal or dangerous.

"Meanwhile, the seasonality pendulum is now swinging back to the bullish side. One remarkable historical studyt lies in a tale of two seasonal investors who started investing 50 years ago, each beginning with $10,000 in an S&P 500 Index fund, but choosing two entirely different 6-month periods during which to invest.

"Investor A chooses to invest only from November 1st through April 30th each year, while Investor B chooses to invest during the other six months of every year, from May 1st through October 31st.

"In the end, Investor A has watched his portfolio grow from $10,000 to over $350,105, a 35-fold increase. However, poor Investor B has watched his initial $10,000 investment barely double to $25,333.

"By selecting the seasonally strong period from November through April, Investor A has captured 95.7% of the available stock market profits of the past 50 years.

"Although one might find difficulty in explaining the cause of this seasonal bias, at least one contributing factor is the traditional Year-End or Santa Claus Rally. 

"And while this November-April seasonality stumbled badly in 2007 and 2008, it’s comforting to see this seasonality now move into alignment with our still-bullish technical models.

"Although this year began in the depths of a raging bear market, it has undergone a remarkable transformation since March. At this point it’s natural to wonder whether this is a sustainable recovery, or if the bull market has run its course.

"We don’t have a crystal ball, but on the positive side, November through April is historically the strongest period for the stock market.  In addition, there is a seasonal occurrence that usually provides higher prices –or at least stability– through January.

"The Santa Claus Rally is a widely recognized truism on Wall Street and it’s actually supported by statistics. Prior to 1970 this rally was a 2-week event, commonly occurring during the last week of December and the first week of January.

"Over the last 40 years the pattern has changed. These year-end rallies have been stronger and they’ve started earlier.

"Perhaps it was a revision in the tax laws that enhanced this yearly occurrence, or maybe the proliferation of mutual funds with their year-end portfolio shuffling, or it might simply be broader anticipation of the event.

"Whatever the stimulus, over the last four decades the average gain from November 20 through the end of January has been +4.2%, which would be an extraordinary +23%, annualized. There are several factors that likely contribute to this seasonal strength.

"First, the holidays are the strongest retail season of the year, often dominated by upbeat headlines. In addition, companies usually make their annual bonus payments at this time, and firms and investors alike make constributions to retirement accounts around the end of the year.

"And, financial forecasts typically issue upbeat forecasts for the new year, paricularly after a recession ends. Finally, let's face it, the holidays tend to life the spirits.

"Whatever the reason, in the last 40 years Santa has rarely missed a beat. By looking at  the performance of the S&P 500 from November 20 through January 31 each year, we note:

•  * Excluding bear markets, only four years resulted in a loss for the period. The biggest decline was in 2002-2003, when a retest of the major bear market bottom caused the Index to drop 6.4%.
   
• * Considering the entire 80 years of S&P 500 data, only two years saw a decline of greater than 10%. That occurred in the middle of major bear markets in 1931 and 1969.
  
• * Conversely, a number of years have seen exceptional gains. Ten Santa Claus Rallies out of the past 80 years have produced gains in excess of 10%. Five of those hefty rallies occurred during the dismal stock market decade of the the 1970s. 

"Does the fact that the market is up over 21% this year rule out a Year-End Rally?  Surprisingly, the answer is no.

"In in a number of years –including 1975, 1995 to 1998, and 2003– strong pre-season gains did not forestall a Santa Rally.  If November’s early strength continues this year, it may be an indication that investors are feeling more secure about the market and the economy in general.

"While there’s no guarantee that Santa will deliver this year, the historical record is encouraging. If 2009 follows precedent, we would expect the S&P 500 to be higher on January 31 than it is today.

"Even if the rally fails to emerge, the loss over these next 10 weeks is usually limited to 2-3%. In the past 40 years, losses have exceeded 3% only four times, in spite of several multi-year bear markets."