The start of December means it’s time for the perennial question for traders: will we see a Santa rally? With lofty valuations and stocks at record highs, the US market may struggle.

Wall Street

Stocks tend to rally into the end of the year. The main US indices – the Dow, S&P 500, Nasdaq 100 and Russell 2000 - have on average gained at least 1.8% in December for every year since 1987, according to analysis from CNBC and Kensho. And the bulk of those gains come in the second half of the month.

Given the propensity for the market to rally in the final month of the year, we have to look at what might stand in the way.

Valuations

Investors may be getting a touch jittery about the valuations. The Dow and SP 500 are up for eight months in a row and valuations are undoubtedly looking a bit stretched. At 32.11 the CASE Shiller price to earnings ratio for the S&P 500 is extremely high and above where it stood before the 1929 Wall Street crash. It’s only ever been higher than this once before, just before the dotcom bubble burst.

Tax reform

The Dow breached 24,000 for the first time on the last day of November but fresh fears over tax reform mean it’s going to struggle to get off to a positive start in December, European indices were a sea of red on the first day of the trading month.

Whether tax reform gets passed is crucial for US markets and a sign of delay would subdue the optimism in the markets.

FTSE 100

Santa casts his festive magic over the UK stock market too. The FTSE 100 has risen in 25 of the last 30 years, meaning it’s the second best month for returns after April, when the new tax year often fires the starting pistol on a fresh round of buying by investors.

On average, the FTSE 100 has risen 2.35% in December going back to 1987, according to our analysis of Bloomberg data. Last year, the index climbed 5.29%, snapping a run of two years in which the market had fallen in December.

The FTSE 100 heads into December well short of all-time highs hit in 2017. Sterling’s gains towards the end of November pushed the main market lower and with signs of progress on Brexit talks, it could be set for more pain if the pound continues to rise.

However, history is on the side of a rally. In years when the market has risen over the course of the preceding 11 months, the gains for the FTSE 100 in December tend to be higher than when it has fallen over the year. And like the US counterparts, the best gains tend to come in the second half of the month, from around December 15th through to year-end.

Stock market history does suggest December is a good time to ride a wave of bullish sentiment. But there are concerns in the main US and British markets that 2017 could be a little less full of festive cheer.

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