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Do You Believe in Santa?

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May 1, 2014
Do You Believe in Santa?

Seasonal market patterns— when prices in general tend to rise or fall during certain periods of the year—are as old as the markets themselves. But should you really “sell in May and go away”? Let’s examine a few long-running axioms and separate reality from myth.

To everything there is a season, whether the subject is shopping, sports, weather, or the markets. The Stock Trader’s Almanac is among many respected authorities to have chronicled and quantified the “Santa Claus Rally” and other such phenomena. But investing and trading these cycles is not as simple as the data may suggest.

Let’s take a look at a few of the most widely cited and popularly followed seasonal patterns, try to get a handle on their validity, and identify a few potential pitfalls they pose in an investing or trading strategy.

Sell In May, Go Away

WHAT IT MEANS: A timeworn adage suggesting investors unload stock holdings ahead of summer, a historically weak period for equity markets.

WHY IT HAPPENS: Not entirely clear, though some investors prefer to avoid summer markets, when trading volume slows and volatility can increase. Also, portfolio managers who’ve outperformed the broader market during the first four months or so of the year may decide to tap the brakes, figuring they only have to mimic the market’s performance the rest of the way to meet their targets.

UPON FURTHER REVIEW... Simple, right? Lock in your gains before Memorial Day, pile the kids into the minivan, and head to the summer lake house for some well-earned R&R. Stockpickers’ efforts to outperform the market in January and February may explain why this adage has largely held water over time.

A money manager who knocked it out of the park in the first quarter shouldn’t risk torpedoing that success by messing around with less-established companies, or so the theory goes. He or she may downshift to a portfolio more in line with the Standard & Poor’s 500 Index, or other broad market benchmark, and hope to ride out the rest of the year with gains intact.

For the Dow Jones Industrial Average, November through April have typically been the strongest months, with the latter clocking an average return of 7.3%, according to the Stock Trader’s Almanac. By comparison, May through October has generated a paltry 0.1%.

In 2013, the S&P 500 actually rallied 11% from the beginning of May through the end of October, although there were a couple of summertime sell-offs where certain chart indicators like the Ultimate Oscillator might have come in handy (see figure 1).

FIGURE 1: SUMMERTIME BLUES? The Ultimate Oscillator function on the TD Ameritrade web platform suggested an overbought condition for the S&P 500 in May 2013 (yellow arrows). Later that summer, the market neared oversold territory (red arrows). Source: TD Ameritrade. For illustrative purposes only.

The Presidential Election Cycle

WHAT IT MEANS: The first two years of a U.S. president’s term tend to be accompanied by poor to mediocre stock market returns, while the following two years are stronger.

WHY IT HAPPENS: A new president, the theory goes, works hard to fulfill campaign promises while the market attempts to sort out the implications; the president’s early efforts may be aimed more at political interests, such as social welfare issues, rather than strengthening the economy. By years three and four, he’s back in campaign mode and may be pushing tax cuts, job creation and other economy-boosting initiatives that could win votes.

UPON FURTHER REVIEW... It was once said that if you only invested in stocks in the second two years of every presidential term, you would’ve missed every bear market.

Gains for the S&P 500 in the year following presidential elections averaged just 1.6%, although that improved to 4% in the subsequent year, according to the Stock Trader’s Almanac. Third-year returns averaged 10.5%, while election years averaged 5.8%.

However, what was once a reliable phenomenon from the Great Depression into the first term of the Reagan administration has become less and less prominent over the past three decades. Since 2003, the presidential cycle has been practically unrecognizable (see figure 2).

This likely reflects the Federal Reserve’s more active role in stimulating the economy, as well as other extraordinary events, such as the dot-com and housing bubbles and the 2008 credit crisis. In the past decade, an investment strategy based on this cycle was likely buffeted by sharp sell-offs and may have missed opportunities to get in on the most recent bull market.

PRESIDENT YEAR 1 YEAR 2 YEAR 3 YEAR 4
FDR 67% 4.1% 39% 25%
Eisenhower -3.8% 44% 21% 2.3%
Nixon -15% 4.8% 6.1% 15%
Reagan -9.2% 20% 20% -3.7%
GHW Bush 27% -4.3% 20% 4.2%
Clinton 14% 2.1% 34% 26%
GW Bush -7.1% -17% 25% 3.1%
Obama 20% 11% 5.5% 7.3%

FIGURE 2: A WEST WING THING. 

The Dow Jones Industrial Average often, though not always, posted a soft performance during a new U.S. president’s first two years; years three and four tended to have outsized returns, as was the case under FDR and Bill Clinton. Source: Stock Trader’s Almanac. For illustrative purposes only.

The January Barometer

WHAT IT MEANS: The performance of the S&P 500 Index during January is a reliable indicator of how the market will perform for the entire year.

WHY IT HAPPENS: Possibly reflects investors jumping back into the markets after a holiday break (more on the Santa Claus rally in a moment); if the year starts off well, they may be compelled to buy more, and momentum builds.

UPON FURTHER REVIEW... This one seems pretty straightforward. If January generates positive returns, so will the full year, and vice versa. Indeed, this indicator has been accurate nearly 75% of the time, according to the Stock Trader’s Almanac. (Note that in January this year, the S&P 500 fell 3.6% from the end of December.)

But here’s one problem: if you’re waiting to enter the market until January is over, you’re going to miss whatever returns were generated that month. Another problem is the whole concept that if January is positive, the year has a higher likelihood of being positive as well.

Remember, another 11 months lie ahead on the calendar. Those months could bring rallies, sell-offs, and other action that will make anything that happened in January a distant memory. Few investors would be happy with a 10% rally in January that ultimately became just a 1% gain after the year shakes out (in 2013, the January harbinger proved accurate—the S&P 500 climbed 5% the first month and went on to surge almost 30% for the full year).

The January Effect/Santa Claus Rally

WHAT IT MEANS: Stocks often begin a rally around mid-December that can continue through the end of February, with small-cap companies tending to perform the best. Often embedded in that time frame is a mini-rally that starts around Christmas and lasts a couple weeks.

WHY IT HAPPENS: There are a few theories, including buying related to tax considerations, holiday bonuses being put to work in the market and general optimism on Wall Street.

UPON FURTHER REVIEW... Small-cap stocks have outperformed large caps in 40 of the past 43 years during the typical January effect timetable, according to the Stock Trader’s Almanac. When it comes to good old Saint Nick, he’s delivered an average S&P 500 return of 1.6% for the 10 days starting right after Christmas through the first week of the new year.

However, small caps tend to be the strongest performers when the market is rallying anyway—regardless of the time of year. This brings us to another pattern: an up-cycle originating late in the year that’s become so reliable it’s known as the “free lunch” effect. As the fourth quarter winds down, many investors sell their losers and start looking for better prospects, which often leaves stock prices lower in October and November.

These lower prices in turn prompt accumulation of shares, which often continues through January and February, pushing prices even higher. Seeking even better returns, some investors venture further out on a limb, speculating on small caps they view as undervalued. That’s more fuel for a small-cap rally.

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