Get Ready Now for the Worst Month of the Year

October

October is the month many investors fear. That’s the month of market crashes in 1987 and 1989. It’s the month in 1929 when stocks crashed, and the Great Depression began in the mind of many. But, there’s another month to fear more, the only month when stocks are down more often than up.

That month is also in the autumn. And, there is a good reason the market crashed so often in the autumn.

A Historically Weak Time of the Year

Until the modern era, dating to the end of World War II, farmers and monetary policy were the leading cause of autumn crashes.

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Money was, for many years, strictly regulated in amount. At times, there was a gold standard and the supply of money was limited by the supply of gold. Since the supply of gold changed slowly, the amount of money in the economy also grew slowly.

At that time, money was real and consisted of gold and silver coins in some cases. That meant money had to be moved physically to meet the needs of the economy.

Farmers in times of real money as opposed to the paper money that we have now, would need access to the money in circulation. Their needs varied in line with the growing season.

In the spring, farmers borrowed money for seed, supplies and often living expenses. In the fall, they harvested the crop and sold it for cash which was sent to the bankers. This was a well known cycle and banks would be able to physically move money to meet demand.

Meeting demand meant moving money to farm country as harvest season approached. The money would be used in the transactions associated with harvest and then moved back east.

Because money was limited, and movements took time, there was a risk of panic if Wall Street traders were over-leveraged and needed immediate access to funds for margin calls. That did happen sometimes, and that created the legend of the autumn panic.

For Some Reason, History Repeats

Now, money is created by central banks and is available to meet demand, even in times of crisis. But there are still autumn panics. We can no longer blame farmers and monetary policy but the data shows we should still be wary at this time of year.

The chart below shows the percentage of time that the S&P 500 index has closed up in every month of the year. The chart uses all data since 1928.

percentage of time that the S&P 500 index has closed up

September is the only month of the year with a losing record. Just 46% of the time the month ends with a gain. Over a shorter period, the data shows the same pattern with September being the weakest month of the year over the past twenty years.

Confirming the Seasonal Pattern With Technicals and Fundamental Analysis

Seasonal patterns like the one shown above are not enough of a reason to trade for most investors. However, they could be useful as one input in the trade decision process.

If the market is going to move lower, chances are the small caps will lead the way and decline first. This is confirmed by the seasonal pattern. For small caps, which can be traded with the iShares Russell 2000 ETF (NYSE: IWM), the weakest month of the year is August, leading large caps by one month.

Given the potential seasonal weakness, other indicators should be reviewed to assess the strength of the market. The weekly chart of IWM is shown below with Bollinger Bands shown as solid lines around the prices and the MACD indicator at the bottom.

IWM weekly chart

We can see that prices have been near the upper Bollinger Band for some time. This is an indication that prices are potentially overbought, meaning there is a potential for a pullback since buyers have been rushing into the ETF and small caps in general.

MACD is a momentum indicator and is shown at the bottom as a histogram. The histogram makes it possible to quickly assess whether the indicator is bullish or bearish. In the chart, MACD is declining and approaching negative territory. It is still in bullish territory but is weakening.

These indicators point to a need for caution in the market. This is confirmed by the fundamentals. The next chart shows the price to earnings (P/E) ratio of the Russell 2000 index. The P/E ratio is shown as bars and price is the solid line.

P/E ratio

Source: Standard & Poor’s

The up trend in price has stalled in the past few weeks while the P/E ratio has been at a significantly higher than average level. The P/E ratio stands at 46, which is more than twice the long term average of that indicator.

A Strategy for Defense

Now, many investors will find they have enough information to develop a strategy for what is statistically the most dangerous part of the year for the stock market. Caution is, of course, warranted.

Investors should consider potentially taking some profits if they are expecting to sell any positions in the next few months. Selling can incur a tax bill but it is better to avoid a loss and have to pay taxes on a gain that it is to suffer a large loss.

Selling will result in cash building up in the account. Many investors also build up cash in their accounts by making regular deposits into their brokerage account. Cash earns very little interest and is often put to work as quickly as possible.

Given the current market conditions, it could be best to put new money to work in large cap stocks. Small caps have more risk and look vulnerable to a selloff. Alternatively, investors could allow cash to accumulate and put it to work later in the year when the seasonal pattern is more bullish.

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