‘Santa Claus rally’ time for stock market? Why investors should dial back their expectations for this seasonal year-end gift.

If recent history holds, then stocks are set to have a good run in the next six trading days as Santa Claus tends to come to Wall Street almost every year. Since 1950, the Santa rally has boosted the S&P 500
SPX
by an average of 1.3% over the seven trading-day range. The benchmark large-cap index closed higher 78% of the Santa Claus trading window in the past 75 years, and gained during that time for the past seven years, according to Dow Jones Market Data. 

This time, though, the stock market has already been in a party mood even ahead of Christmas, with some market watchers, including Yardeni Research’s Ed Yardeni thinking the Santa rally has come “ahead of schedule.” 

U.S. stocks are sitting on hefty gains at the close of a rollercoaster year. The S&P 500 jumped 4.1% in December, just 0.9% shy of its record set nearly two years ago amid growing optimism that the Federal Reserve may begin cutting interest rates as early as the first half of 2024, a fervor that policymakers attempted to rein in since last week’s FOMC meeting. 

Opinion: Santa Claus is coming to town and bringing presents for your stock portfolio

But a relentless rally in the run-up to the official Santa rally indicates some of Santa’s largesse may have already been delivered, said Pete A. Biebel, senior vice president and senior investment strategist at Benjamin F. Edwards. 

“I do think that the market is a little bit extended, so our expectations for this traditional Santa rally period should be dialed back a bit,” Biebel told MarketWatch on Friday. 

Biebel points to the midweek dip on Wednesday which made the Dow Jones Industrial Average
DJIA
down 475.92 points, or 1.3%, for its biggest one-day percentage decline since October. The blue-chip index ended a streak of five straight record finishes as a strong year-end rally briefly lost momentum, according to Dow Jones Market Data.

While there wasn’t any clear fundamental trigger for the selloff, some Wall Street analysts think a surge in trading of zero-day to expiry options (0DTE) should be blamed for the pullback. Others said the derivatives that have exploded in popularity this year were just one piece of the puzzle, as overbought technical conditions and low year-end trading volumes also were cited as likely factors. 

The “air pocket” for stocks on Wednesday was an omen or a red flag that the markets have that potential for steep drawdowns, Biebel said. “It doesn’t mean it has to happen, but it’s a warning that the market is not as rosy as it seems — there is potential trouble below the surface.” 

See: Chasing the Santa rally? Look out below!

However, some analysts suggest investors not to bet against the seasonal momentum, especially during the bull market with a strong uptrend which took the three indexes off their October lows, said Adam Turnquist, chief technical strategist at LPL Financial. 

“Stocks are overbought, but the market can stay overbought for longer than most people expect, especially at this stage of a bull market,” Turnquist told MarketWatch via phone. 

Meanwhile, stock-market returns during this time frame have historically correlated closely to returns in January and the subsequent year. Since 1950, the S&P 500 has generated an average forward annual return of 10.4% when Santa comes to town. That is well above the return when Santa doesn’t show up, which is only around 4%, according to data compiled by LPL Financial. 

“There’s the potential [for a Santa rally] but we’ll likely see a little bit of a hangover as well as a reset in January or February from these overbought conditions,” he added. 

Time will tell if investors receive the seasonal presents that history promises in 2023, or if an overly extended rally will let the Grinch steal Christmas. After all, Santa rally is more of a “curiosity” than a phenomenon, said Biebel. 

U.S. stocks finished mostly higher on Friday, with three major indexes scoring their eighth consecutive positive week. The Dow Jones Industrial Average rose 0.2%, while the S&P 500 was up 0.8% and the Nasdaq Composite
COMP
jumped 1.2% this week, according to FactSet data.