Who Stole The Christmas Rally?

According to text book scenarios, global equity markets become a lot more volatile when September appears on the calendar. Weakness usually doesn't genuinely kick in until the third or fourth week and extends until mid-October when a sharp recovery announces itself. Once we move into November the underlying positive trend re-establishes itself with further gains booked in the run-up to New Year.

This typical year-end scenario is so deeply engrained in the investment community's psyche that every year, around this time, market commentators and investors already start looking forward to the gains that should follow between November and year-end, with January usually a positive extension into the new calendar year.

The irony is we haven't seen such a typical build-up to the Christmas break for many years now and this year the Australian share market is certainly not following the script.

October is not finished yet, but as things stand right now, the Australian share market is going to add more gains on top of September's and that's a rather rare occurrence. Even more so because there has been divergence with commodity markets, which are mostly all down since September, and with equities in China, Europe and the US that are all staring towards a (potentially) mildly negative October performance.

Of course, Australia following its own path this month can be interpreted in many ways, both positively and negatively, and history shows this doesn't necessarily spell bad news for the local share market. It's just that, usually, US equities walk the more solid path leading into year-end and Australia somehow manages to keep up or to catch up. The jury remains out whether this year it will be the other way around.

Thus far, it has become obvious Australian equities are enjoying solid buying support even with company AGMs opening up quite a few disappointments. In the US, the glamour has dropped off corporate margins and profit growth this third quarter reporting season.

Probably the biggest question mark for Australian investors is the fact that usually a few weeks of weakness is built-in the script for the last four months of the year. If it doesn't happen in either September or October (which is rare) than November might oblige instead, but this is certainly not a given. Back in 2004, for example, equities simply climbed, and climbed, and climbed, and climbed and never even looked like they were seriously going to pause along the way to a higher ending for the year.

As I point out every year, September and October usually are each other's opposites with September likely to bring weakness and October the recovery. According to some market analysts in the US, October and November have a similar offsetting relationship, but my own research has shown no evidence for this. This means: November doesn't have to bring weakness simply because September and October haven't. Besides: US equities seem to be following the September-October script which possibly increases the chances they will resume this year's rise in November and then finish off the year on a new high.

Talking about the annual Christmas rally is a bit like talking "recession" or "hard landing" or "profit warning" everyone seems to have a different interpretation for what are very commonly used terms. If we take a very simplistic approach and compare indices at the beginning of September with the last trading day of the year it is easy to conclude that in most years, indices close the year higher. Under the present circumstances, this is hardly an encouraging conclusion with the Australian share market currently more than 200 points higher since early September.

Also, in most years the final two weeks in December (with Xmas in the middle of it) see a steady rise in share prices. This is a period when most investors are out of action, volumes drop and junior funds managers and daytraders who had a bad year try to book a few extra gains. Leave these two weeks out of the equation and the question whether equities will book additional gains this year becomes a little less straightforward to answer.

Let's have a look at what has happened in the years past.

Last year, there was no rally whatsoever - no matter which interpretation used. Equities in both the US and in Australia followed the usual script for September and October but then extreme volatility ensued and after an initial sell-down and recovery in November, it was all down, down, down from early December. Not even the final two weeks in December saw share prices rise. Here's the chart for the ASX200 during the period:

In 2010, US equities forgot all about the usual script and they gradually ground their way higher, with a benign pause along the way in November. In Australia, however, things were a lot more volatile and the market effectively peaked in early November, sold off, clawed its way back up and then moved sideways into the new year. Christmas rally? Never stood any chance at all (unless we start measuring from early December).

2009 throws up big divergence between markets in the US and in Australia. In the US, equities experienced high volatility in both September and October, but reset at a higher level in November and then simply staid at that level, with high volatility, until a small step-up late in December. In Australia however, the share market never managed to recover from the October fall, with high volatility effectively translating into lower share prices, until those last two weeks in December.

The final four months of 2008 are best described as succinctly as possible: down. No rallies whatsoever, not even in the final two weeks. The same applies to 2007 when equity indices peaked in October and early November and then started preparing for the coming bear market. Those were two consecutive years of no Christmas joy for equity investors.

Year-end 2006 was rather unusual as well with US equities grinding their way higher. Similar to 2010, Australian equities were more volatile and, after a flat November, they played catch up in late December.

Up until this point, and depending on what definition we use for "Christmas Rally" it can be argued the Australian share market hasn't seen one in the past six years (!).

How about 2005? Yet another year of divergence. In the US, equities slide from September until deep in October, stage a rally then effectively move sideways into the new year with a leg down in the final week of the year. In Australia, however, the script looks different: September sees a steady rise towards 4700, then a sharp fall (300 points) in October, a steady rise followed by weakness in November and early December, then a rally towards 4800. It's not the perfect sample, but its the best we've encountered so far and most historic data analysis will simply show a gain of 300 points over the final four months (circa 6.5%).

Note that was seven years ago.

Finally, 2004 provides us with price action that closely resembles how we remember the script for the final four months of the calendar year. We have weakness in September (but not much), followed by weakness in October, then a rally into November and more moderate extension of gains all through December. In Australia, we again saw divergence from the US market that saw Australian equities effectively grind their way higher between September and year-end. Note the absence of any noteworthy weakness in either September or October.

Can 2004 be the blue print for Australian equities this year? I am willing to bet most investors are hoping the answer will be "yes".

I note that share markets in the US and in Australia often follow diverging paths leading into year-end. More importantly, the idea of a genuine Christmas rally seems to be a figment of the past - or worse: maybe it was never there in the first place? Not even during the bull market from 2004-2007 could investors count on a sustained rally in the weeks leading up to Christmas.

That, however, won't stop us from thinking about it.

By Rudi Filapek-Vandyck
Editor FNArena