Seasonality is a term that refers to the recurring tendency of the stock market’s performance to behave in a pattern according to the time of year, day of the month or other cyclical occurrences such as presidential cycles. Understanding seasonal patterns and cycles that influence the markets can allow you to increase your odds of success. Take for example the old adage “Sell in May and Go Away”, not only does it roll right off the tongue, it is a time tested strategy based on the stock market’s monthly performance averaged over many years. In addition to this strategy I will be discussing some other influential seasonality patterns and how to profit from them.
It’s important for me to note that history doesn’t repeat itself exactly. Skeptics will point out that markets do not conform to these patterns 100% of the time, however historical data shows us that market fluctuations very frequently do follow predictable patterns. It is pretty hard to argue with statistics.
“Sell in May & Go Away” (Best 6 months switching strategy)
This is a well known strategy based on monthly historical data revealing the tendency for the market to perform stronger on average between the months of November and April and weaker between May and October. The strategy therefore would be to either be underweight or completely out of equities during the “worst 6 months” and overweight or fully invested in the “best 6 months.” Academics largely ignore this strategy as it goes against the efficient-market hypothesis. However, when you back test this strategy, it is hard to ignore that it is quite profitable.
The chart pictured above is from Stock Trader’s Almanac, the bible for seasonality. It shows that if you had invested $10,000 in the Dow Jones during only the “worst 6 months” beginning in 1950, you would now have lost $6,500. In contrast, if you had invested during only the “best 6 months” you would have a current total of $2.3 million! Even when compared to the simple buy & hold strategy, the returns from the “best 6 months” strategy are undeniably better.
There are several key indicators to watch for in January that really set the stage for the rest of the year.
The January Effect
Investment banker, Sidney Wachtel, coined this phrase “January Effect” to describe the tendency of small cap stocks to outperform large cap stocks in the first month of the year. This effect is likely due to end of the year tax-selling that drives down the price of small-cap stocks making them cheap and undervalued at the beginning of the new year. The “Free Lunch” strategy is used to capitalize on this tendency. In this strategy you buy beaten down small cap stocks at the end of December and sell in February, taking advantage of the January effect.
The January Barometer
The January Barometer describes the predictive nature of the month of January. The belief is that January’s return (positive or negative) is a good indication of the rest of the year’s performance. Since 1950 this indicator has accurately predicted the direction of the market 88.9% of the time. For example, if January is positive there is a strong chance that the rest of the year will also be positive. This tendency has largely been attributed to congress reconvening in the first week in January including the newly elected members of congress. In addition the President gives the state of the union address outlining goals and laying out the annual budget.
Santa Claus Rally
The Santa Clause Rally is the tendency for stocks to rally between Christmas and the New Year. There are plenty of theories that try and explain this phenomenon, including people buying to take advantage of the lift of the “January effect.” The absence of a Santa Claus Rally can be a warning flag for the year to come. For example at the end of 2007 the Santa Claus rally period had a negative return of -2.5% What followed in 2008 was the worst stock market decline since the great depression. Furthermore, in 1999 the market had a negative return of -4% during the Santa Claus period. This was followed by the burst of the tech bubble in the next year which sent stocks tumbling.
(Chart Source: Humble Student of the Markets)
The presidential election cycle has a statistically significant influence on the market. Take a look at the two charts below and you will notice that the 3rd year of a president’s term has historically been the best performing year. In the third year the market has returned an average of 18% and has been positive 94% of the time since 1946! To take advantage of this pattern it would be advisable to be overweight equities in the third year and underweight in the weaker years of the presidential cycle.
(Chart source: GoBankingRates)
One of the explanations for this tendency is that the third year is also the pre-election year, in which a president will go to great lengths to get re-elected. While in office a sitting president will try and manage the economy in a manner that will set the stage for good economic times leading up to the election.
While these patterns and cycles are averages and won’t always play out exactly as they did in previous years, over the long run taking advantage of these seasonal and cyclical market anomalies may help you to reduce risk and profit from uncertain markets.