A Review Of Market Seasonality

From time to time I am asked about my theory of market seasonality.  I published a column on this at the end of April but wanted to rerun it because we've had a lot of new people come over to reading the blog, they've heard me reference it now a few times and so I wanted to put this article out there where it was easier for them to find.  Today, as I have done in the past, I  thought I'd reprint this piece that was originally posted to our blog on April 6, 2012. It was part of a set of articles done in a question and answer style and published serially back then.  {Note:  Highlighted bullet points.}  Not much about this has changed since I originally wrote this article.  I think it's a timely reprint given where we are in the year and current seasonal patterns.  Note that as I'm writing this many major market indices have experienced returns in the first four months of 2021 that are approaching or have exceeded their historical annual returns.  Below is the reprint.

You place a lot of emphasis on market seasonality. Why is that?

We have touched on this in past client letters here  here and here. Basically there 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.

As I've said in the past one of the reasons I think this pattern works is the philosophy behind how most of what we refer to as institutional money is invested. Institutional money is a generic term for large institutions such as pension plans and large asset managers such as mutual funds. It is managed on a relative basis usually tied to a specific benchmark and is also managed so as to not give up the assets. By relative basis I mean as an example in a market that loses ten percent, institutional accounts that go down only 8% are said to have outperformed their peer group. That influences how their portfolios are set up. Institutions generally start a year with similar economic and valuation expectations for stocks.

Institutions have a very strong incentive to be heavily invested in the early months of a new year. They are afraid to fall too far behind their benchmarks. Their thinking is similar to that of a baseball manager at the beginning of a long season. The manager knows you don't win a pennant in April but you can lose one during that time. 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. Stocks will either need unexpected positive news {i.e. better than expected earnings news or higher economic forecasts for example} or prices will begin to stall out. One of my concerns right now is that the markets have had such a strong move that much of the economic expectations are already priced into stocks. If companies don't excessively move the needle higher on earnings and sales going forward than investors, especially those with a shorter term horizon, may begin to lock in their profits.   {Updated Note with this reprint:  While the last two sentences in this paragraph were written back in 2012, these words would apply especially well to this article as it is reprinted at this time in 2021.}

Stocks will fall of their own weight unless there are marginal new bidders for their shares. Summer is typically a down period for Wall Street as the news flow often dries up {unless it’s bad news. It is amazing how many international crises begin in the late spring/summer period. Both World Wars, the Korean War, 9/11, the First Gulf War and the 2008 banking crisis are examples of this.}

Summer is also when analysts begin to fine tune their expectations for stock prices as clarity begins to enter the picture about year-end economic activity. Stocks will also begin to discount any lower revisions or negative economic news during this period of seasonal weakness. Once this discounting process is completed stocks will usually then begin to rally sometime in autumn. The cynical amongst us 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 wants to get paid. So there is a strong incentive to boost share prices during the 4th quarter of the year.

What A Client Asked Me The Other Day

A client asked me the other day about the possibility of a 20-30% correction in the markets in the next five years.  The question was in response to some article he'd read that noted many of the gauges reportedly used by Warren Buffet show the market historically overvalued.  Please note that I don't know what article he's referencing.  

Here's my response:

"I will tell you that at some point over the next 5 years there is a very high probability we'll have a market correction that has the potential to be between 15-30%.  The historic volatility of the market is around 15%, meaning that in any given year there is a very high probability of a stock correction around 15%.    At 4,377, the S&P 500 experiencing a 25% correction would  take the index back to 3,283.  That would take the market back to about where it was in November 2020.  Of interest to that level is that's also where stocks traded in early 2020 before the pandemic became a problem.  The trick in any decline is trying to figure out if we're in what would be described as a typical correction in prices or a set of circumstances that would morph into something much worse.  To get much worse in my opinion you typically need a few things to happen.  You need an unexpected event or usually the unraveling of a financial bubble in assets.  If there's a bubble in any asset classes right now it's in certain speculative stocks and perhaps crypto.  While exciting for some these areas of speculation don't draw in enough money to pose a systemic problem to the investment world.  In terms of an event posing a systematic risk, you'd need something out of the blue like a foreign policy crisis or the virus taking a unexpected and deadlier turn I think for us to see a major impact on stocks.

As for quoting Buffett, Warren has said a lot of things over the years but I like his comments on volatility and I trot these out for clients in periods of market weakness.  Traders tend to love volatility but investors hate it when it leads to a decline in their accounts.  Presumably nobody minds volatility when stocks move higher.  As for Buffett and what he's said on stocks and volatility, here you go.

'The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities — Treasuries, for example — whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more volatilethan cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskierinvestments — farriskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk.  Popular formulas that equate the two terms lead students, investors and CEOs astray.”

*Long ETFs related to the S&P 500,  in client account and personal accounts, although positions can change at any time    We reserve the right to change these investments without notice on this blog or via any other form of verbal, written or electronic communication.

Kicking The Sand Out Of The Shoes

Years ago when I worked for a certain brokerage firm, the head of our division got on the squawk box {Yes that's where CNBC got the name for their show} and gave a speech each Tuesday after Labor Day to the troops all over the country.  It was always referred to as the "Time to Kick the Sand Out of the Shoes" speech because he always made that comment somewhere in his talk.  The message was simple.  Summer's over.  Time to get back to work.

In the wheel of the year under which Wall Street marks time, July and August are the only periods when making money takes a backseat to more leisurely pursuits.   As we've discussed many times in the past, folks in the investment class, particularly those out east, tend to be more interested in being at the beach or in the mountains than in front of their screens.  It's one of the reasons that August can sometimes be volatile.  Events come up and the "A" team is away.   

Now though summer is over.  September and early October with all their historical ugly ghosts looms.  After that  will likely come the mad dash into the end of the year for institutions to show positive numbers for the clients who pay Wall Street's bills.   As we begin to contemplate colder weather here in the north, here's  a partial list of what the investment community is going to be watching:

In 2021 everything leads back to Covid-19.  What will be the path of the virus this fall.  What will be the economic toll from it.  What kind of restrictions will be put in place and are there perhaps more deadly variants of the virus lurking out there.  For now I believe the vast majority of Americans are chasing to go about their lives in spite of the virus.  That will change I think if a mutation shows up that more directly impacts children.  It all ends with Covid right now so stay tuned for that.

What will be the Federal Reserve's policy towards  interest rates and tapering in the coming months.  A tighter money supply has traditionally been a headwind for stocks, especially if we tighten too quick.  For now that doesn't look to be an issue but things can change.

When will people come back to work.  Bottlenecks in the work place are becoming endemic and threaten economic growth.  People need to get back to their jobs. 

How will tax policy, the democrats 3.5 trillion dollar budget plan and the 1.5 trillion dollar infrastructure plan fare in Congress?

And of course the deteriorating relations between us and the Chinese.

Any Black Swan that comes over the transom.

That's the main list.  Others could come up.  Guess it's time to kick the sand out of the shoes!