Historically, the months of November, December and January are referred to as the “best three month stretch” in the stock market thanks to average S&P 500 gains of around 4% during this period going all the way back to 1950, according to the Stock Trader’s Almanac.
Why do stocks have a good run in the Winter time when frost is biting fingers and snow is on the ground? The reasons are many, some simple and some much more complex. But as you will see, they combine to create powerful forces that cannot be ignored.
The Holiday Season Impact
The changing temperatures are one reason for consumers to boost spending levels as they stock up on warm clothes and other supplies needed for Winter. But the holiday season is also noted for presents and family get-togethers, whether Thanksgiving or any of the other noteworthy holidays, which combine to create the highest sales figures for retail firms during these months.
Consumer spending isn’t some idiosyncratic measure of the strength of the economy that can easily be dismissed, either, but rather it accounts for nearly 70% of U.S. GDP, according to data from the Bureau of Economic Analysis. To give you a sense of how large the holidays retail sales are, they were reported at $942.6 billion last year.
Window Dressing by Funds
December is also notorious for “window dressing,” a strategy that involves selling underperforming stocks and buying high-performing ones. It is typically employed by fund managers who want to improve the appearance of their portfolios performances prior to the year-end.
The Journal of Finance has reported that this approach typically benefits smaller stocks more so than larger ones because the lower market capitalizations make them easier targets for quick portfolio adjustments.
Indeed the data backs up the assertion with small-cap stocks outperforming the market by nearly 2% during the last week of December.
The January Effect
Another phenomenon that is typically repeated from one year to the next is the January Effect, which involves selling losers in December for tax purposes and buying them back in January.
It tends to favor small-cap stocks and is so well-documented that a paper in the Journal of Financial Economics revealed that from 1927 to 2008, the smallest quintile of stocks outperformed the market by an average of 8.5% in January.
Interestingly, the same study demonstrated that this outperformance is generally more pronounced among stocks that had declined the previous year, offering an angle for savvy investors.
Some argue that all of these trends work in part also because investors expect them to occur so they become self-fulfilling prophecies. Perhaps there is some truth to that as behavioral economics suggests that investors are more likely to buy rather than sell during times of optimism, such as holiday periods.
In fact, The Journal of Behavioral Finance found that market-wide optimism metrics tend to increase by 6% during the holiday season, creating a favorable environment for markets to rise, but they don’t fully explain away the buoyant environment, which is where Cem Karsan’s theories find a home.
You’ve heard of the “Santa Claus Rally,” but renowned quant trader Cem Karsan coined the term “Vanna Charm Flow” to describe similar year-end market dynamics and provide a groundbreaking perspective on market seasonality, particularly for the November to January stretch.
Karsan’s Vanna Charm Flow
First let’s explain these terms before we dive into how they affect market prices. Vanna and Charm are second-order Greeks in options trading that describe how market makers have to adjust their hedges, ultimately influencing stock prices.
According to Karsan, these flows are significant drivers of market trends during the year-end, complementing the retail-driven “Santa Claus Rally.”
The Journal of Derivatives published a research paper indicating that market volatility often decreases when Vanna and Charm flows are positive. Market data from the past decade or so shows that these flows are usually positive from mid-November through January, providing yet another explanation for the bullish trends during these months.
Karsan has also spotlighted the importance of options expiration dates, especially during the holiday period when market makers, who are often net short options, have to adjust their positions as the options expire. This can cause significant price movements, especially if it coincides with other seasonal trends like increased retail activity.
Indeed, a fascinating statistic that surfaced following research of options expirations over the last decade indicates that large-cap stocks often experience a 1.5% upward swing in the week leading up to monthly options expiration during the November-January period.
Behavioral Economics, Karsan-Style
Karsan, who oversees Kai Volatility, places a strong emphasis on behavioral economics as a seasonality factor, much like traditional theories.
He posits that investor psychology, driven by end-of-year optimism and New Year resolutions, interacts with market structures like options market flows to create strong bullish trends.
Behavioral economic studies have found that when optimism is coupled with positive market flows like Vanna and Charm, the market has a tendency to rally up to 8% more than during other periods.
Further, Karsan discusses volatility often, or more precisely how the lack of it during the holiday season can lead to a bullish market because it encourages more risk-taking. When you combine this with positive Vanna and Charm flows, the case for a bullish November to January becomes compelling.
Remarkably, the historical data from the VIX index confirms that volatility tends to decrease by about 15% from November to January, further encouraging market bullishness.
While Karsan focuses heavily on market structure and behavior, he acknowledges that positive economic data during this period can act as a catalyst, amplifying already bullish tendencies induced by market structures and investor psychology.
Job growth is one such indicator and it’s no surprise to discover that it pops during this period as more hands are needed on deck by retailers primarily to cater to the spike in consumer demand.
In fact, the U.S. Bureau of Labor Statistics has reported that job growth in November and December averages about 250,000 new jobs per year over the last decade, thereby creating a macro tailwind to the existing bullish market structures.
Why Do Stocks Go Up In Winter?
Stocks often go up in Winter because of the effects of Vanna and Charm flows coupled with spikes in consumer spending over the holidays, window dressing and higher seasonal job growth.
It’s notable that Cem Karsan’s insights into market seasonality from November to January offer a nuanced, data-intensive approach that any retail investor would be wise to consider. They are rooted in evidence while still painting a comprehensive and clear picture of market tendencies during these months.
If you combine the Santa Claus Rally with the January Effect, and Karsan’s cutting-edge analysis the end result is clear to see, predictable bullish forces that should be respected. To be abundantly clear, these forces cannot be stopped anytime soon.
The fact they are repeatable from one year to the next means more often than not a bullish year-end rally should be expected.
It’s typically only when markets are in the red from January 1 to October 31 that some of these bullish tailwinds may be tempered because, for instance, window dressing will no longer be relevant. Still, many underlying forces of strength will surface time and again during this period.
It’s one of the reasons why we built out a dedicated seasonality section so you can see how these forces affect your preferred stocks.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.