Gaming the Santa Claus Rally, Y2K Edition

Conventional wisdom says markets rise during the last week of the year, a phenomenon that's quaintly referred to as a Santa Claus rally.

Often, it's the result of stock-chasing, window-dressing fund managers attempting to load up on the year's hottest stocks, while dumping their losers, just before the books close on Dec. 31. The moves make them look good, at least for that one moment in time -- which is the only moment that matters in their annual reports.

This year, many market watchers say the rally should be particularly merry. But they've been saying it with a kind of certainty that is never a very good thing when it comes to the stock market. Because as soon as something -- anything -- gets priced into the market, the market tends to react poorly if that something fails to materialize.

Contrarians at Christmas

"If everyone's expecting it to do one thing, maybe it won't," says Charles Biderman, president of Trimtabs.com Investment Research. His Santa Rosa, Calif.-based firm tracks fund flows, and is calling for more than $14 billion to come into funds in December, up from just $3.2 billion last year. And if smart portfolio managers know that -- which they most certainly do -- their pre-emptive actions may head Santa off at the pass.

"If the market is expecting big inflows, and an up market after Christmas, the logical thing to do is to get as fully invested as you can by now," Biderman says. "So if the cash is already invested and they're waiting for new cash that doesn't come, well, let's just say the market is going to be very vulnerable to bad news between now and year's end."

That said, the argument that the year-end rally will be especially robust this year is a compelling one. During the fourth quarter, cash has been pouring into fund coffers at an are-you-sure-that's-right rate. January is only expected to bring more. With that outlook, the reigning view is that the pressure will be on to keep putting cash to work.

So it Flows Monthly cash flows to mutual funds, in billions
Month	1998	1999
October	$2.4	$20.4
November	12.8	20.5*
December	3.2	14.7*
*Estimates for Trimtabs.com. Source: Investment Company Institute, Trimtabs.com Investment Research.

Those bloated flows, if they continue, will meet a uniquely thin market during the last week of the year. Because Christmas falls on a Saturday this year, the next week will be a prime target for vacation requests. If the junior portfolio managers left at work have lots of cash to play with, volatility's likely to pick up as they fight over a handful of hot Nasdaq names.

"It's like a traffic jam of people trying to get on the freeway to own some of these hot names in this select group," says Ryan Jacob, manager of the Jacob Internet Fund. "Clearly there's a supply-demand problem because there's just a very small, select group that the managers want to own."

Given those conditions, it's not hard to call a rally during that time.

"It's all obviously going to trade higher," says Todd Clark, head of listed trading at Volpe Brown & Whelan. "There's some uncertainty if there's going to be problems surrounding Y2K, but my sense is that if the markets were worried about that, we wouldn't be trading up right now."

Spooky

Of course, this year, Y2K is the exact kind of bad news that could produce the unexpected spook -- and knock Santa off his sleigh. While investors have shown a surprising lack of worry about the once-in-a-millennium problem, it's an unknown mutual fund managers are watching.

"I think there still are enough questions surrounding Y2K that a lot of managers don't want to be at bare-bones minimum levels of cash," says Gus Sauter, chief indexer at Vanguard Group. They may actually want cash on hand during the last week of the year in case investors decide they want some back.

From that perspective, portfolio managers may not have the incentive to put all that cash to work during the last week of the year after all -- especially if they've been busy getting it into the market in recent weeks.

Jeff Van Hart, manager of the (TEQUX Quote)Transamerica Premier Equity fund, says he's currently got just 1% to 2% of his portfolio on the sidelines.

"If I had billions of dollars sitting in cash, I would try to get most of that to work before that last week," Van Harte says. "What tends to happen anyway at the end of the year is the winners get marked up and the losers get sold even more. So if you want to stay positioned in the winners, you're going to pay a higher price during that last week."

Which means the smart money may very well stay away -- or already be in place -- in the days before the ball drops in Times Square. Especially if that's the place no one's expecting it to be.