Volatility on 34th Street?

Regardless of whether you were naughty or nice, St. Nick does not have a magic sack with sky-high late-December returns. Photo by GraphicaArtis/Getty Images.

Ok, so Nat King Cole we aren't. But all the same, tis the season for candy canes, hanging baubles on fir trees, and making market predictions-for December and 2015 alike. Some of them are somewhat rational endeavors, like full-year forecasting. Others are less useful. This story is about those less useful predictions. Like those foreseeing big gains in December as the Santa Claus rally kicks in. And those proclaiming bouncier markets await next year. Public Service Announcement: Neither we, nor anyone else, has any rational basis for predicting short-term movement or future volatility.

First, to the December stuff, starting with the mythical Santa Claus rally, which says returns between Christmas and New Year's Day are utterly smashing as thin trading volume and good cheer carry stocks up, up and away.^[i] We would love to believe this one, because who doesn't want stocks to soar!^[ii] Alas, it is just as much false mythology as its seasonal brethren, the January Effect, Sell in May and September Stinks.^[iii] In the last 86 years, returns between the last trading day before Christmas and the last trading day of the year were positive 65 times-a 75.6% frequency. That isn't far from stocks' overall frequency of annual positive returns, which tells you the Santa window just meshes with stocks overall tendency to rise more often than not. Nor were all those 65 positive instances gangbusters. As Exhibit 1 shows, most were ho-hum-we've had plenty of days bigger than most of them.

Exhibit 1: Santa's Bag of Toys, 1928 - 2013

Source: FactSet, as of 12/22/2014. S&P 500 Price Index, 1/1/1928 - 12/31/2013. Returns calculated from the last trading day before Christmas through the last trading day of the year.

Or, if you prefer a bell curve, here you go.

Exhibit 2: A Partridge in a Pear Tree

Source: FactSet, as of 12/22/2014. S&P 500 Price Index, 1/1/1928 - 12/31/2013. Returns calculated from the last trading day before Christmas through the last trading day of the year.

In short: No, Virginia, there isn't a Santa Claus rally. Maybe the year finishes hot, or maybe not! Maybe investors get a big case of the happies and bid stocks way up over the next eight days! Or maybe they get all Grinchy and markets give us a big fat humbug. There is zero way to know. Quick moves are sentiment-driven, and sentiment is impossible to predict. Feelings are often erratic and irrational.

The same logic applies to volatility, which many say is about to make a big comeback. Reasons vary. Some say we're in for more bounces because quantitative easing (QE) is over-ignoring that markets were plenty volatile during QE's first few years. Others say things have just been too quiet since mid-2013, and we're due-forgetting volatility has never operated on a schedule and the past doesn't predict the future. Some say rate hike fears will catch up with stocks. Some say volatility in oil and other commodity markets will spill over. Never mind that rate hikes aren't inherently negative and whatever is known to oil markets is already known to stock markets-one doesn't lead the other.

While the reasoning behind all these volatility warnings is wrong, in our view, that doesn't mean 2015 will be another low volatility year. Maybe it is bouncier! There just isn't any way to know. Volatility is unpredictable-again, it's driven by sentiment, and you can't know how anyone will react to anything ever. Maybe we do get a rate hike pullback! Or maybe fears will be baked into pricing whenever the Fed makes its move, and stocks rise. For any or no reason. Maybe we get a correction-a drop of -10% to -20% over a few weeks or months-or maybe we don't. Those happen for any or no reason, too.

Underlying the volatility chatter is some misguided implied advice: that we should all somehow prepare for more wobbles. Now, on one hand, we agree! Emotionally, everyone should steel themselves for ups and downs and remind themselves, every day, wiggles are normal. Even big ones. They're the market's way of trying to shake out the weak and make folks sell low, buy high and miss stocks' long-term returns. We'd encourage folks to keep that in mind whether they expect markets to be extra-wiggly or not. It's just a good life lesson, and it could spare you from heartache whenever that unpredictable volatility strikes.

But tactically, there is nothing to prepare. Your long-term strategy should depend on your longer-term goals, cash flow needs, time horizon and other similar factors. Tactical shifts based on the market's outlook might make sense now and then, but only if your longer-term forecast has changed. Like, if you are darned sure a bear market is forming. Then, it could make sense to reduce your stock exposure, provided you think more downside is ahead of you than behind you. But otherwise, reducing stock exposure-which is what the "get ready for volatility NOW" crowd generally urges-is fruitless. Stocks can do great in volatile years. "Preparing" for them with more cash, fixed income, stop-losses, put-options or other derivatives carries a big opportunity cost-the potential to miss returns you need to reach your goals.

Our advice: Tune out all the short-term noise, whether it's about Santa cheer or 2015 zig-zags, and think longer term. Stocks are still in a bull market, and that bull markets still doesn't look poised to end in the foreseeable future. The world economy is growing and firmer than most perceive. Earnings are growing, corporate balance sheets are healthy, and businesses are investing. The political backdrop is benign, with gridlock keeping most Western world politicians from messing things up. Sentiment is getting optimistic, entering that sweet spot where folks typically bid stocks higher as their confidence grows. Regardless of what Santa might bring or whether more wiggles are in store, if your goals and objectives require some degree of long-term growth, this is a time to be in stocks.

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^[i] Insert Santa metaphor here.