Seasonality

Chart of the Day takes a look at market seasonality: "Today's chart illustrates the Dow's average performance for each calendar month since 1950 (blue columns) and the average monthly performance of the Dow from 1950 to the present (gray line). Today's chart illustrates that the Dow has tended to perform best during the last several months and first several months of a calendar year. During the middle of a calendar year, the Dow has tended to struggle (with the exception of July). It is worth noting that there have been only two calendar months during which the Dow has declined on average -- June and September."

I have marked in a red box above on the chart the statistical period of market weakness.  We have commented in several past posts on market seasonality. Specifically back on March 23rd we noted:

"{T}here are seasonal variations or patterns that come into play in most years......The study of these bullish and bearish phases means that I accept as a given that stocks at some point this year will experience a sell off between 8-20%. This is simply the normal course of how markets behave in most years. It is part of the seasonal variation of how in a normal investment year stocks will cycle between bullish and bearish phases as measured by money flows."

While market declines can come at any time, statistically stocks are most prone to major sell offs in between the months of March and October. There is not enough space to go into all the theories of why this pattern persists and of course there is also no law that says this has to occur. However we have to add this factor into the equation given the fact these seasonal patterns exist and given where we are in the calendar."

One of the reasons I think this pattern works is the way that most institutional money is invested. Institutional money is managed on a relative basis to a specific benchmark and is also managed so as to not give up the assets. In a market that loses ten percent for instance, institutional accounts that go down only 8% are said to have out performed their peer group. That influences how their portfolios are set up. Institutions generally start a year with some expectation of the economy and what stock assets ought to be worth by year's end.

Because of this institutions have a very strong incentive to be heavily invested in the early months of the new year. They are afraid to fall too far behind their benchmarks. To borrow a baseball analogy, "you don't win a pennant in April but you can lose one". As the year progresses and in particular if stocks have advanced in the first few months, equities begin to look less attractive on year end expectations. They either need an extra bump up {better than expected earnings for example} or prices will begin to stall out.

Stocks will fall of their own weight unless there are marginal bidders for their prices. Summer is typically a down period for Wall Street as the news flow dries up {unless its bad news. It is amazing for instance how many international crises begin in the late spring/summer period. Both World Wars, Korean War, 9/11, and the First Gulf War are examples that come to mind here.} Summer is also the beginning of the period when analysts begin to fine tune their end of year expectations for stock prices as clarity begins to enter the picture about year end economic activity,

Stocks will begin to discount any lower revisions or negative economic news during this period of seasonal weakness. They will usually then begin to rally sometime in the fall. For one thing there is better clarity at this point about expectations regarding year end earnings. For the cynical amongst us, we also know that the only print that matters for most money managers is the one shown when the market closes on December 31st. To put it simply Wall Street want to get paid. So there is a strong incentive to boost prices during the 4th quarter of the year.

This year is shaping up to be a text book example so far of what I've just described. We discussed back in December our expectations that stocks as represented by the S&P 500 had the potential to trade between 1,350 and 1,400 by year end 2011. On May 2nd the S&P 500 printed a close of 1,361.22. By early May we had already reached the lower end of my price targets. Since the estimates I use are available to nearly everybody then it is likely that consensus expectations for most analysts were somewhere near my own levels. Stocks at this point, in order to rise, needed that extra push in the form of better economic news. That has been decidedly lacking these past few weeks. As such stocks first stalled out and have since retreated slightly, being down about 5% from their early May highs.

Where we are going now is any body's guess. Markets aren't nearly as overbought as they were a few weeks ago yet they are also not back to oversold levels that would suggest by our work that a longer duration rally is in the short term offing. It is likely that we will meander a bit more within the trading range that we seem to have now carved out. Our work indicates that trading range is set between S&P price levels of 1,260 on the downside and 1,350 on the upside. That equates to about 3% to the downside from Friday's close and 4% to the upside from our current levels. We still have the defensive pages of both the game plan and the playbook open. Also I would note that we have been at a short term NET MARKET NEGATIVE since back in early April. You can click here for a definition of what that term means.

While we remain defensively oriented, prices of specific securities are beginning to reach levels that look attractive to us. Another week or two of this same action could lead us to change our ratings.

*Long ETFs related to the Dow Jones Industrial Average in certain client accounts. Long ETFs related to the S&P 500 in client and personal accounts.

Chart of the Day Link: Seasonality