An Introduction to Seasonality & Stock Market Cyclicality

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 below is from Stock Trader's Almanac, the bible for seasonality. It shows that if you were to invest $10,000 in the Dow Jones during only the "worst 6 months" beginning in 1950 you would now have lost $6,500 as opposed to investing during the "best 6 months" in which case you would have a current total of $2.3 million. Even when compared to the simple buy & hold strategy, the returns that result from the "best 6 months" strategy are undeniably better.

The chart below is from Stock Trader’s Almanac, the bible for seasonality. It shows that if you were to invest $10,000 in the Dow Jones during only the “worst 6 months” beginning in 1950 you would now have lost $6,500 as opposed to investing during the “best 6 months” in which case you would have a current total of $2.3 million. Even when compared to the simple buy & hold strategy, the returns that result from the “best 6 months” strategy are undeniably better.

January Indicators

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.

Screen Shot 2015-10-13 at 4.50.36 PM

(Chart Source: Humble Student of the Markets)

Presidential Cycles

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.

Screen Shot 2015-10-13 at 5.35.47 PM(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.

The Dangers of Leveraged ETFs

Since the 2008 financial crisis exchange traded funds have become popular investment vehicles for traders and investors alike. Leveraged ETFs are a type of exchange traded fund that track a benchmark or underlying index and use leverage to maximize the performance of the underlying benchmark (typically an index or commodity). They are offered in the form of 2x (ultra) or 3x (pro) leverage and can be either bullish meaning long the underlying asset or inverse, meaning short the underlying asset. For example a popular 3x leveraged crude oil ETF is UWTI. If the price of crude oil goes up 2% the price of UWTI will go up 6%. Some other popular leveraged ETF’s include:

  • SSO – 2x Ultra S&P500
  • AGQ – 2x Ultra Silver
  • NUGT – 3x Daily Gold Miners Bull Shares
  • DWTI – 3x Inverse Crude Oil
  • YANG – 3x Daily China Bear Shares

These instruments have quickly rose to popularity and have seen huge inflows amid the recent volatility in commodities. Despite they’re growing popularity, few retail investors and traders truly understand the dangers associated with these complex products. This lack of understanding is concerning considering their growing popularity. CEO of BlackRock, Larry Fink has even publicly commented on the systemic risk they pose to our financial system by saying “leveraged exchange-traded funds contain structural problems that could “blow up” the whole industry one day.” This is an alarming statement seeing as Fink’s company BlackRock is the largest ETF provider!

Leveraged ETFs allure retail traders with huge daily price swings. Especially inexperienced traders who are looking for investments with big returns to help grow their portfolios. In addition to offering big returns they also offer traders leverage without needing a margin account. It’s normal to see these ETF’s move 5% or more in a day. Wild daily price swings like these have traders licking their chops and many impulsivly jump right into them without fully understanding how they work.

One of the biggest mistakes people make with leveraged ETFs is buying and holding them as long-term investments rather than using them as short term trading vehicles. The intended purpose of these products is to take advantage of daily price movements. Therefore, the appropriate way to use leveraged ETFs is to day trade them. The reason they pose a greater risk when holding for a longer time frame is because every night these funds go through rebalancing where the fund manager has to re-allocate the funds assets to accurately track the underlying index or commodity. Rebalancing every night causes price decay known as beta slippage. The longer the time they are held for the greater the potential for slippage. To learn more about leveraged ETFs and the math behind slippage check out this video. 

Another quality of leveraged ETFs that make them potentially dangerous is that they are often difficult to analyze. Many retail traders don’t realize that typical technical analysis and charting doesn’t work well on leveraged ETF charts due to the daily rebalancing. Instead you must analyze the chart of the underlying asset.

Leveraged ETFs can be useful for day traders looking to leverage their position without using margin however things like rebalancing are things people need to consider before using these products. In addition, management fees and slippage are two main characteristics of leveraged ETFs that should make them unattractive to long-term investors. If you do decide to trade these products, it’s imperative that you have a thorough understanding of some of the risks that are associated before using them.

Best Online Trading Websites and Resources

Here’s a list of my favorite online trading websites & resources. These sites are essential to beginning traders. Each site is unique and when used together will help you to stay informed as a trader. — Great platform for sharing ideas, charts and trade with other retail investors. StockTwits can be a powerful tool for gauging sentiment on particular stocks as well as see which stocks are trending, all in real time. — Awesome site for creating and sharing visually appealing charts. Truly a perfect site for technical analysts. TradingView allows you to share charts directly to Twitter or StockTwits. — The best source on the web for research and information on exchange traded funds. — Very popular for charts and heat maps of the markets. I find it the most useful to check either pre-market or post-market. It’s packed with useful data and information including insider activity and major news. — Crowdsourced earnings estimate site that provides insight to the real whisper number to beat. Super useful site during earnings season. — Great site for staying up-to-date with the stocks on your watch list. Freelance writers post articles analyzing particular stocks as well as global macro trends.

My Most Trusted Market News Sources 

Both Market Watch and Bloomberg are my favorite financial news outlets. They both report the major financial news but each have different editorial articles. Download the apps on your iPhone and turn on push notifications to stay up-to-date.