RQA Economic Insights: November 2024 — Richmond Quantitative Advisors

RQA Indicator Spotlight: Unwrapping the Santa Claus Rally - A look at year-end seasonality

The “Santa Claus Rally” is a term often used to describe a seasonal trend where stocks experience a positive push into the year-end. This phenomenon has been observed over many years, with market returns in December showing a tendency to be favorable, particularly following a strong January-November period. While December is often associated with positive seasonality on its own, historical data suggests that strong performance earlier in the year can amplify this effect. Most years, the market ends higher by November, which creates favorable conditions that often carry into December. This is partly driven by investor behavior, end-of-year positioning, and other market forces.

We start by looking at historical market return data to see whether a strong start to the year has historically led to a strong finish. The scatter plot below illustrates the relationship between S&P 500 returns from January to November (x-axis) and the corresponding December returns (y-axis) for the years 1990 to 2023. Each dot represents a specific year, showing the pairing of cumulative January-November performance with December performance. The trendline reveals a positive relationship, indicating that when the S&P 500 performs well from January to November, December returns are also more likely to be positive (albeit a relatively noisy relationship, as is typical with financial return data). This supports the concept of the "Santa Claus Rally," where strong year-to-date performance may pave the way for additional gains at year-end.

By grouping the data into categories, we can further explore the seasonal effect. The following table examines the relationship between January-November returns and December returns for the S&P 500. Year-to-date performance (January-November) is categorized into three groups: 'Strong Positive Returns' (greater than 10%), 'Positive Returns' (between 0% and 10%), and 'Negative Returns' (less than 0%). The table also shows the corresponding average December returns for each group.

The data reveals that when the S&P 500 achieves strong positive returns (greater than 10%) from January to November, December returns average an impressive 3.1%. For years with moderate positive returns (0% to 10%), December returns are relatively flat at 0.3%. Conversely, when January-November returns are negative, December returns tend to average -1.2%. Across all years, the average December return is 1.5%. This breakdown reinforces the idea that stronger year-to-date performance is often associated with a higher likelihood of positive December returns.

Key Drivers of the year-end effect

This effect is driven by several key factors, including increased investor activity, structural flows, and behavioral tendencies. Below, we break down the main components that contribute to this rally:

The Re-leveraging Effect
When markets produce gains from January to November, investors’ collateral rises proportionally. For example, a 20% portfolio increase boosts available collateral by 20%. To maintain leverage ratios, investors may "re-lever" by increasing the size of their positions, creating buying pressure. This cycle of re-leveraging supports year-end flows and can reinforce a positive feedback loop into December.
Seasonal Flows & Dealer Gamma Dynamics
December sees heightened portfolio adjustments from institutional investors (rebalancing, gain locking, tax-loss harvesting) and retail seasonal buying. Structured flows, like corporate buybacks and index fund adjustments, peak during this time, creating on-balance buying pressure. Additionally, positive gamma from options hedging further amplifies demand as dealers buy more equities when prices rise (this part is a bit technical, we know). Further, the shortened trading calendar intensifies these flows, as the structural buying dynamics noted above need to be squeezed into a tighter timeframe, creating a self-reinforcing cycle of upward momentum.
Front-Running & Year-End Positioning
As the Santa Claus Rally gains recognition, investors increasingly “front-run” expected flows, buying early to capitalize on anticipated gains. This behavior drives demand ahead of year-end but can create risks if the market becomes overextended. Nonetheless, this positioning is central to the rally as participants seek to benefit from historical year-end strength.

Probability, Not Certainty

While the Santa Claus Rally has a presence in past data, it’s important to note that this trend is not guaranteed. Markets are influenced by a broad range of factors, and no strategy can offer certainty in terms of returns. The concept of a year-end rally aligns with the idea of probability rather than certainty—positive January through November returns are associated with a higher likelihood of positive December returns, but exceptions can and do occur. Even as positive year-to-date performance might support increased flows into the market, broader economic or market-specific events could easily disrupt the trend. As always, it’s wise to maintain a balanced view and integrate risk management into any strategy based on seasonal trends.

Conclusion

In summary, the Santa Claus Rally is a seasonal pattern rooted in both historical data and investor behavior. Factors such as re-leveraging, fiscal year-end trading dynamics, and front-running activity combine to create supportive flows that often drive December’s performance. However, as with any market trend, there are no guarantees. While the rally is statistically more likely during strong years, understanding these underlying patterns can help investors better anticipate and navigate year-end market movements.

Economic Forecast Model

As of the end of October, the growth metric in RQA’s Economic Forecast Model increased to 0.41, up from September's 0.27 and August’s 0.24. This marks another consecutive month of steady growth, indicating stabilization and successfully avoiding a decline into negative territory. The current trend points to a gradual pace of improvement, with positive expectations highlighting resilience rather than rapid acceleration.

*Source: Analysis by RQA. Data from U.S. Federal Reserve; Bureau of Labor Statistics; Norgate Premium Data; Institute for Supply Management.*

The RQA Economic Forecast Model represents a consolidated composite of key economic leading indicators and market-based explanatory variables. The goal of this composite model is to present a holistic measure of primary U.S. economic growth drivers and their trends over time. (Additional detail on the model’s construction is provided here.)

Values above the zero-line are indicative of positive U.S. economic growth expectations in the near-term, and therefore, indicate economic strength and lesser chance of recessionary pressure. On the other hand, values below the zero-line represent the opposite - a more negative outlook and more elevated probabilities of the U.S. experiencing an economic contraction.

TAKING A CLOSER LOOK AT THE ECONOMIC DRIVERS

The RQA heat map of economic drivers provides additional insight into the U.S. growth outlook. By examining trends across sectors—such as labor, industrial activity, and financial conditions—we gain a more detailed understanding of the economy's health and trajectory. This breakdown helps us anticipate potential shifts in growth expectations and inflation trends.

The Labor market shows gradual softening, with Non-Farm Payrolls steadily declining, indicating slowing job growth. Initial Unemployment Claims (inverse YoY) have improved in recent months, while the Employment-to-Population Ratio and Average Weekly Hours Worked remain relatively flat or slightly negative, suggesting limited momentum in the labor force. That being said, the absolute levels of each of these indicators continue to show a fairly strong U.S. labor force.

In Commercial Output, persistent weakness is evident across manufacturing and housing sectors. ISM Manufacturing PMI remains negative throughout the year with no signs of recovery, while residential real estate permits and industrial production indices also reflect subdued activity. However, the ISM Services PMI has demonstrated resilience, showing volatile but generally positive growth, with a strong rebound in October 2024.

The Income and Consumption indicators reflect resilience, driven by steady growth in real personal incomes, which highlight strong wage dynamics. Consumer spending, as measured by personal consumption expenditures, has maintained moderate growth around 3% YoY. However, retail sales remain negative for much of the year, with only slight improvement as of October 2024, suggesting some lingering weakness in discretionary spending.

In Financials and Sentiment, the picture is mixed to positive. Equity markets have shown robust growth, with the S&P 500 delivering a 36% YoY return through October 2024. Corporate bond spreads have improved after earlier widening, but yield curve spreads remain flat or inverted, indicating cautious sentiment and potential concerns about future economic growth. Consumer sentiment has been volatile but finished on a strong note, reflecting renewed optimism.

The Inflation and Money Supply section indicates a controlled and stable inflation environment, with CPI and Core PCE remaining elevated but within target levels (2.3%-2.7%). The M2 Money Supply, which had been contracting earlier in the year, has turned positive, suggesting improving liquidity and potential support for economic activity.

MARKET REGIME DISCUSSION

The market has spent most of the month digesting the implications of the election results. Overall, investors were relieved by the decisive outcome, avoiding the risk of a contested election. With reduced anxiety, and consistent with historical election patterns noted in our analysis last month, implied volatility as measured by the VIX declined significantly in the days following the election. General market shifts since the election include the following:

Stock Market Reactions

In the immediate aftermath of the election, U.S. equities experienced a sharp rally, driven by optimism over potential regulatory rollbacks and lower corporate tax rates. Key sectors like Consumer Discretionary and Financials led the surge, while some "Magnificent 7" stocks saw gains of 3% to over 7%. However, this momentum waned as policy uncertainties emerged, leading to mixed sector performance. Financials continued to outperform, while Communication Services and Technology sectors experienced declines.

Currency & Interest Rates

The U.S. dollar strengthened moderately after the election, reflecting expectations of fiscal easing and higher growth, similar to patterns observed after the 2016 election. Analysts suggest that additional dollar appreciation could occur if tariffs targeting China are introduced, which may also impact emerging markets and commodity prices. Interest rate expectations shifted higher, with markets anticipating elevated U.S. rates relative to other advanced economies. However, rate differentials have adjusted only modestly compared to prior elections, leaving room for potential further increases.

Sector-Specific Trends

Small-cap stocks rallied on the expectation of tax cuts and a focus on domestic production, with regional banks benefiting from reduced regulatory burdens. In the Energy sector, stocks showed strong momentum, with many trading above short-term moving averages. However, this performance was not accompanied by a corresponding rise in oil prices, signaling potential volatility ahead.

Economic Growth

The growth forecast model has improved for the third consecutive month, reflecting a steady upward trend. This aligns with continued positive GDP projections both from market analysts and the Atlanta Fed's forecast output. As concerns about sluggish growth diminish, attention is shifting toward the potential for an overheating economy, rekindling discussions about inflation risks.

Economic Quadrant Update: Inflationary Boom

Our economic quadrant model continues to position the economy in an "inflationary boom," with growth metrics beginning to move off the zero bound. Inflation remains elevated, while near-term growth forecasts are picking up, signaling a transition toward a less fragile regime.