In everyday living, we expect certain seasonal patterns to unfold every year. In the fourth quarter of the year, we expect Halloween to give way to Thanksgiving and then Christmas. Each holiday has its own customs and decorations and each is unique. But each follows a well-defined pattern. It’s human nature to expect this level of predictability to be seen in the stock market simply because we like to see some sense of order in the chaos of the market action. The result of this is popular strategies like “sell in May and go away.”
Testing has shown that you can achieve almost all of the market gains and avoid the periods of greatest risk by selling at the beginning of May and staying out of the market for the next six months. That means the time to buy is the beginning of November. This is just one of the seasonal trading strategies we find in the last three months of the year.
Seasonal strategies are an effort to make sense based on the calendar out of the chaos of the markets. Many of these strategies were developed by noting that certain events, like market crashes, tend to occur at the same time of the year. Most investors know about stock market crashes in October 1987 and October 1929. By selling in May, investors avoided these crashes. But this strategy also avoided the bear market that unfolded in the summer of 1991 and the 36% decline in the panic of 1907 along with steep selloffs in the Panic of 1857 and the Panic of 1837.
Before the Federal Reserve was created in 1913, panics were fairly common in the fall. Without a central bank, money supply moved across the country in response to demand. In the fall, demand was usually the greatest in the western states where farmers were bringing in crops. Cash was needed to pay for the crops and the cash was often used to pay off loans to banks which then shipped the cash back east. With physical cash in short supply in eastern cities, including New York where the stock exchange was located, panics were relatively common in the fall. There were other factors and that explains why there were panics in some years and not in others but there was a logical explanation for why selling in May made sense.
Because there are clearly defined rules, in this case sell at end of April and hold cash for six months before reinvesting, we can test a seasonal strategy. The Dow Jones Industrial Average offers a long history and we can test using data from January 1900 through the end of April 2016, a 116-year test period.
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For the test period, the Dow delivered an average gain of 5.2% a year. For the best six months, the average annual gain was an identical 5.2%, equal to 100% of the Dow’s gains. For the worst six months the Dow lost an average of 0.3% a year. Testing supports the idea that it could be best to sell in May and go away. If you did so, you need to invest your cash at the beginning of November.
Markets don’t crash every year so many investors will not move to cash for the worst six months. The seasonal strategy can still be helpful. Investors can make more aggressive trades in the best six months and be more conservative in the worst six months.
Another reason to consider being more aggressive in the fourth quarter is the fourth quarter rally, a tendency for stocks to perform best in these three months. Data for the S&P 500 index since 1928 is shown in the chart below. Stocks show a gain 73% in the fourth quarter, far better than the results seen in any other quarter.
It’s also important to use the fourth quarter to prepare for the January effect which is the tendency of small cap stocks to perform better than average in the first month of the year. To benefit from the potential gains of the January effect, you should consider buying small cap stocks or ETFs with exposure to this segment of the market in December. Two ETFs to consider are iShares Russell 2000 (NYSE: IWM) which tracks one of the most popular small cap indexes or iShares Micro-Cap (NYSE: IWC) which tracks stocks too small to make that index.
Small caps could be the best trade for the fourth quarter rally. The chart below shows the performance of the IWM ETF by quarter. The results for the fourth quarter are even more consistently profitable than they were in the S&P 500. This chart shows the results since 2000 when the ETF began trading.
The January effect is based on the idea that investors will sell stocks late in the year to recognize losses for tax purposes if they have losses on trades. In many cases, they will then buy the stocks back 30 days later to comply with tax rules that disallow losses if the stock is bought back in less than 30 days. This effect was first written about in 1942. In recent years, analysts have noted the January effect can take place in December as traders try to profit from the expected buying of stocks. Based on this shift, it could be best to buy small cap stocks earlier in the fourth quarter to benefit.
Seasonal strategies in the fourth quarter also include a number of short-term trades.
The Santa Claus rally is the name of a strategy that takes advantage of the tendency of stocks to rise in the week between Christmas and New Year’s Day. Buying and holding stocks for the last five trading days of the year and the first two trading days after New Year’s has been a winner 75% of the time with an average gain of 1.4% for the seven days. The performance in Christmas week is well above average. In an average week, the stock market shows a gain about 55% of the time and the average gain is less than 0.25%.
Less well known is the “turkey trade.” The S&P 500 gains an average of 0.64% during Thanksgiving week, buying at the open the Monday before Thanksgiving and selling at the close the Friday after the holiday. The trade has been a winner 67% of the time.
Finally, we have a more complex set of trading rules for traders to consider. Studies have shown that stocks setting new 52-week lows in December tend to outperform the market for the first six weeks of the new year. Stocks making new lows in December could be the stocks investors are selling to generate tax losses. Buying these stocks sets up a potential win when investors buy the stocks back after the 30-day waiting period required by tax rules.
The specific rules for this strategy are to buy stocks making new 52-week lows the Friday before Christmas. If there are too many stocks to buy, select the 5 or 10 stocks with the largest loss over the past year. Hold these stocks until February 15 and sell at the close that day. On average, this strategy has delivered a gain of more than 12% a year since 1974.
Many traders use seasonal strategies to boost their profits. The strategy can be as simple as tilting to a more aggressive investment posture for the fourth quarter. Small caps could prove to be the best choice for investors this year as they have been many years in the past.