Three Holiday Indicators to Bring You Cheer

Commentary: Gifts from the market, whether you’re naughty or nice

BOCA RATON, Fla. (MarketWatch) — After exposing the popular Hemline Index as an old-fashioned myth, I decided to take a closer look at a trio of well-known but misunderstood holiday indicators: The Santa Claus Rally, the January Effect, and the January Barometer.

Can these indicators predict the market’s future, or is it just wishful thinking?

Although everyone wants to believe in miracles, especially during the holidays, hope alone won’t make the market go up. And yet, some of these indicators have been extraordinarily reliable in the past.

Here comes the Santa Claus Rally

According to market lore, the stock market is destined to surge from Christmas until the beginning of the New Year. As a result, many investors rely on the magic of the so-called Santa Claus Rally to stuff their portfolios.

The theory is that optimistic money managers restock their portfolios with financial goodies fueled by bullish investors and year-end bonuses, causing the market to rise. Believers in this theory also surmise that the majority of market pessimists have taken the week off.

Although naysayers are often skeptical of the Santa Claus Rally, MarketWatch columnist Mark Hulbert says there is strong historical support for this seasonal pattern, which “has the best risk-adjusted performance of any timing system I have tracked over the last two decades,” he writes.

Jeffrey Hirsch, editor in chief of the bestselling Stock Trader’s Almanac, confirms the validity of the Santa Claus Rally. “The market has had an average gain of 1.5 % during the last five days of the year and the first two days” of the new year, Hirsch says. On the other hand, if the market is spooked during that week, “there might be more ominous market forces at play,” he warns. “If Santa fails to call, bears may come to Broad and Wall.”

The January Effect

In the early 1980s, University of Chicago graduate student Donald Keim, now a professor of finance at the Wharton School of the University of Pennsylvania, observed that small stocks outperform large stocks in January more than in other months. The idea was that individuals and large institutions sold stocks at the end of the year and bought back in January. This pattern continued for nearly every year from the late 1920s through the late 1980s.

Eventually, this idea turned into the so-called January Effect, coined by Keim. The theory: if small-cap stocks outperform large-cap stocks in January, it could be a good year for the stock market. If small-cap stocks underperform large-cap stocks in January, it could be a bad year.

Although many financial reporters still write about this pattern, it has lost much of its power over the last decade. Fortunately, there is another seasonal phenomenon that is more reliable than the January Effect.

The January Barometer

Often confused with the January Effect is the January Barometer, devised by Yale Hirsch in 1972. The theory: Whatever happens to the Standard & Poor’s 500-stock index (CME:INDEX:SPX) in January will set the mood for the rest of the year. “As January goes, so goes the year,” says Hirsch.

The rules are simple:

1.If the S&P is up in January, the market is likely to have an up year.

2.If the S&P is down in January, the market is likely to have a flat or down year.

Although the January Barometer has had a 78.3 % accuracy rate since 1950, according to Hirsch, it does have flaws. “It’s had six major errors during this time, and will probably be wrong in 2010,” Hirsch concedes. “Like any short-term timing system, it can be influenced by random events.”

Nevertheless, he points out that the S&P’s 16 % correction from April to July confirms the pattern; i.e. every down January is followed by a new or continuing bear market, a 10 % correction, or a flat year.

Although no one is suggesting that you make big bets based solely on the results of these holiday indicators, they can provide important clues. In addition to doing insightful analysis and research, astute traders and investors also measure the mood of the market using technical, sentiment, and economic indicators.

No matter what side of the market you’re on, many pros believe that January is still the most important month of the year, especially during that first week. Therefore, with the holidays quickly approaching, it might be useful to mark January on your calendar now.