The so-called “January effect” and other seasonal patterns like “sell in May” have long been part of market vernacular, but investors need to separate reality from myth.
Seasonal factors in the markets have inspired a few popular myths about trading patterns
Seasonal stock market patterns—certain periods of the year when prices in general seem to rise or fall—are as old as the markets themselves. But now that the robins are singing, should you really “sell in May and go away”? Maybe not so fast.
Instead of just accepting the old sayings about when to sell stocks, it’s important to examine these long-running axioms and separate reality from myth. Remember, we’re discussing past performance, and past performance is no guarantee of how markets might act now or in the future.
That said, 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 “sell in May and go away,” the “Santa Claus rally,” and other such phenomena. But investing and trading these cycles isn’t necessarily as simple as the data may suggest.
Let’s 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.
What it means: This timeworn adage suggests investors consider unloading stock holdings ahead of summer, a historically weak period for equity markets.
Why it happens: It’s 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 (assuming the first four months went well).
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. Stock-pickers’ efforts to outperform the market in January and February may explain why this adage has lasted so long.
For the Dow Jones Industrial Average (DJI), November through April have typically been the strongest months, clocking an average return of 7.2%, according to the latest version of the Stock Trader’s Almanac. By comparison, May through October generated just 0.6%.
Still, it’s probably not accurate to say the summer months are the worst. Between 1945 and 2020, the months of May and July recorded average gains of 0.30% and 1.06%, according to investment research firm CFRA. June has averaged a slight advance, while August averaged a small loss. September ended up being dubbed “the summer bummer” because it’s been the worst month of the year in the post-World War II era, averaging a 0.56% loss and declining in price 55% of the time.
But selling in May and going away definitely deserves some skepticism. Figure 1 shows how the S&P 500 Index (SPX) behaved in the summer of 2020, when any investor who took that adage seriously would’ve been unhappy by autumn. In that particular year, the post-pandemic recovery explains a lot, but it wasn’t the only recent summer where stocks had a nice run. The summers of 2018 and 2019 saw rallies, too.
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. Although this doesn’t happen every year, it’s happened often enough that some investors notice.
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. Anticipated year-end dividends and payouts may also be a factor.
Upon further review ... “The January effect” now starts in mid-December and favors small-cap stocks, according to the Stock Trader’s Almanac. Additionally, most of this takes place in the last half of December. In a recent stretch, small-cap stocks 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 1.3% for the last five days of the old year, starting right after Christmas through the first two days of January. 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 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 at times has continued 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.
Still, like everyone else, investors may be skeptical whenever they hear about a “free lunch.” They may ask, “What’s the catch?” A small-cap rally may look great if it happens, but once that fuel runs dry, investors could be running on empty.
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, according to some analysts.
Why it happens: Possibly, the January effect reflects investors jumping back into the markets after a holiday break; 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.
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 idea 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.
Another concern is that the January effect has registered 10 major errors since 1950, according to the Stock Trader’s Almanac. January 2018 and January 2020 were the most recent. The S&P 500 Index rose sharply in January 2018 and ended up falling 6.2% for the full year. It fell 0.2% in January 2020 and rose that year by more than 16%. It’s not too dependable when you see a supposed “effect” not work out two years out of three.
What it means: According to some stock market watchers, 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. “Post-election years have a long history of losses, bear markets, recessions, and wars,” the Stock Trader’s Almanac explained.
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, they are 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’s been said that if you only invested in stocks in the last 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 3%, although that improved to 4% in the subsequent year, according to the Stock Trader’s Almanac. Third-year returns averaged 10.4%, while election years averaged 6.0%.
By the way, the first year of a new president is still the weakest year, but it’s been moving up in the world. That 3% figure in the most recent Stock Trader’s Almanac compares with less than 2% in a previous version from not long ago. The first year of President Obama’s first term (2009) and the first year of President Trump’s term (2017) saw the Dow Jones Industrial Average (DJI) gain 18.8% and 25.1%, respectively. That kind of smooths out the election cycle effect, making it unclear how relevant it still is.
*Through April 5, 2021. Data sources: Stock Trader’s Almanac, TD Ameritrade
Since 2003, the presidential cycle has been practically unrecognizable. For example, consider Wall Street’s strong performance during the first year of the Donald Trump administration.
The change in this “presidential pattern” 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. A set of tax cuts early in Trump’s presidency also helped inject optimism into stocks. 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.
The Biden presidency began in 2021 with more fiscal stimulus and the Fed keeping rates at record lows. Stocks jumped out of the gate, helped by easy monetary policy. But some analysts have said the market might pay a price later in Biden’s administration if the Fed needs to lift rates to stop the economy from overheating or proposed higher taxes take effect. With all that in mind, investors could be forgiven if they feel leery of the presidential cycle going forward.
Some say the market tends to run in long-term patterns that can be tracked over many years. The “Decennial Cycle” is one that says the market works in 10-year segments, with each decade tending to have three bull market cycles and the strongest and longest appearing to favor the middle part of a decade, according to the Stock Trader’s Almanac.
Though the Decennial Cycle is in the almanac, its editors suggest not putting too much emphasis on it today. “Other than the extraordinary fifth and zero years ... the stock market is more influenced by the quadrennial presidential election cycle,” the almanac stated. “Also, the last half century, which has been the most prosperous in U.S. history, has distributed the returns among most years of the decade. Interestingly, the Nasdaq suffered its worst bear market ever in a zero year.”
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