- Historically speaking, the last three months of the year have been the most successful for the German stock market index, the Dax.
- Several factors can trigger the year-end price rally that often occurs. However, this does not mean that a strong December is guaranteed.
- In any case, long-term investment always reduces seasonal effects.
It’s cold, the nights are drawing in, flu jabs are in the news and yellow leaves stick to damp streets. It must be November, which means it's time for analysts and traders at stockbrokers and banks to speculate about the possibility of a year-end rally on the financial markets. Often, they’ve already started heralding a final stock-market spurt by Halloween at the end of October. Some soothsayers narrow it down to a "Santa Claus rally" in the trading days at the turn of the year – or predict the "January effect", a period of particularly high returns just after New Year.
But why is the end of the year such a significant moment in the financial calendar? And is there such a thing as a year-end rally?
"The tendency for share prices to rise at the end of the year can be seen from historical data,” says DWS fund manager Tim Albrecht. “For example, the last quarter in each of the last 39 years was, on average, one of the most profitable for the Dax."
December was the second-best month of the year, with a monthly increase of 1.95 percent. Since 1988, there have been only eight Christmas months in which the headline German index recorded a loss.
The tendency for a positive "Christmas effect" can also be observed internationally. For example, the market-leading S&P 500 index in the USA has grown at an average rate of 1.4 percent in December since its launch in 1928. For the Dow Jones US benchmark index it was 1.32 percent. The last month of the year was the strongest on average for both indicative indices.
The trend for a year-end rally can also be observed outside Germany.
Historically, the Dax rose on average at the end of the year
The last three months of the year are among the most successful for the Dax. In the past, the only month with better average monthly performance was April.
Various impulses drive the rally
But why should the market perform particularly well in December? One theory is that institutional investors such as pension funds, insurance companies and banks optimise their balance sheet at the end of the year for tax purposes.
"If investors sell securities that have performed poorly for them over the year, the losses are offset against profits and the tax burden is reduced,” explains DWS expert Albrecht. “The freed-up capital is redeployed in securities that are performing well – which in turn can boost overall market momentum."
This explains the "January effect". Indeed, market data also show that a pronounced price increase is to be expected at the beginning of the new year, particularly for smaller companies. Between 1928 and 2018, for example, this effect was observed in 62 percent of years. Some investors may buy more before the year end in anticipation of the New Year effect and thereby drive the markets for Christmas.
Christmas bonuses and consumer confidence sometimes seem to drive the markets.
Reduced sales, bonuses and portfolio adjustments
But there are other ways to explain the seasonality of the markets at the end of the year. For example, some market experts attribute the rather temporary "Santa Claus rally" to large-scale investors going on holiday over New Year and closing their trading books. Private investors then boost the market for a few days with comparatively thin trading volumes.
"Another explanation for the year-end rally is that the bonuses paid in the finance and other industries compound the psychological effects of the pre-Christmas big-spender mood,” explains Albrecht. “This leads to increased risk-taking – not least among private investors. Christmas and annual bonuses are invested in the stock market, driving valuations."
Finally, a similar idea suggests that the rally is due to institutional investors such as insurance companies or pension funds receiving fresh capital from recurring premium payments at the beginning of the year. They then use the last few months of the year to pile existing funds into equities. They put money into this risky asset class in anticipation of having to invest the fresh capital in less risky assets, such as bonds, at the beginning of the new year to meet their prescribed risk profile: not too conservative but also not too risky. In this case, the year-end rally would also be down to portfolio adjustments by large investors.
A December rally is not guaranteed
"It remains unclear whether one of these explanations is decisive or a mixture of all,” says Albrecht. As with the stock market adage of "sell in May and go away", there is no guarantee that stock markets will surge upwards at Christmas."
Ultimately, investors should use relevant valuation methods when deciding to invest. They would therefore be better advised to keep an eye on interest rate trends, companies' earnings, the general economic outlook and the geopolitical situation rather than simply relying on a predicted year-end rally.
And the longer investors hold their investments, the less effect seasonality has. Private investors can avoid these fluctuations by, for example, making monthly contributions to regular savings or private pension plans. Then they don't have to worry about being in the year-end rally.