Stock Market Seasonality

by Troy

Everything in this world has cycles, including the stock market. Stock market seasonality is when the stock market tends to perform better during certain times of the year and tends to perform worse during certain times of the year (from a probability perspective).

Whether or not you recognize it, you’ve probably heard about the stock market’s seasonality from mainstream financial media. This includes:

1. Santa Claus Rally (also called the Year End Rally)
2. January Effect
3. Sell in May and Go Away
4. Presidential Cycle

Mainstream financial media tends to place too much emphasis on seasonality factors. In my opinion, seasonality factors are of secondary importance when compared to understanding the stock market’s fundamentals and technicals. Much of the stock market’s seasonality is just random.

1. In a big enough universe, there are always going to be patterns and high-probability situations (e.g. seasonality) that occur for no reason other than random chance. Most seasonality patterns don’t make much sense. Traders and investors often discover seasonality patterns and then make up a reason to “explain it” when in reality, these “patterns” occur merely due to random chance.
2. Seasonality changes over time and it is inconsistent. Hence, seasonality doesn’t always work, and you have no idea when it will stop working. For example, did you know that from 1950 – present the best months to invest in the S&P 500 are from November – April, but before 1950 the best months to invest were from April to November? This is an example of seasonality changing over time.

With that being said, here is an in depth look at the stock market’s popular seasonality patterns. Let’s look at 4 things:

1. The random probability of the stock market going up on any given month
2. The Santa Claus Rally (also called the Year End Rally)
3. “Sell in May and go away”
4. The Presidential Cycle

Random probability of the stock market going up on any given month

To understand seasonality factors such as the Santa Claus Rally, we need a benchmark to compare it against. Here’s the random probability of the stock market (S&P 500) going up on any given month, from 1950 – present

1. January: +1.03%
2. February: +0.04%
3. March: +1.17%
4. April: +1.45%
5. May: +0.26%
6. June: -0.03%
7. July: 1.08%
8. August: -0.05%
9. September: -0.46%
10. October: +0.79%
11. November: +1.52%
12. December: +1.65%

The following chart shows the stock market’s performance (S&P 500) during every single month, from 1950 – 2018

Santa Claus Rally (also called the Year End Rally)

Santa Claus Rally (also called the Year End Rally) refers to the stock market’s tendency to go up in December, particularly around the holiday season (i.e. Christmas – New Years). The standard explanation for this seasonality pattern is that “investors tend to be happy around the Christmas, so they buy more stocks and push stock prices higher).

But does this seasonality actually exist? Or is it just hocus pocus?

For starters, there is no definitive definition as to when the Year End Rally season officially begins and when it officially ends. So let’s look at different time frames.

Here’s the S&P 500’s performance during the final week of each trading year (the most precise definition of the “Santa Claus Rally”).

rom 1950 – present, this turns $1 into $1.32. That’s an average of +0.4% during each year’s “Santa Claus Rally” seasonality.

As you can see in the above chart, the stock market did well during the Year End Rally from the 1950s – 1970s, after which the Santa Claus Rally’s performance has been more erratic. This just shows you that seasonality works until it doesn’t. Things that don’t have a fundamentally driven reason tend to break down and change over time, no matter how strong the correlation.

Here’s a looser definition of the Santa Claus Rally. This is what the S&P does during the final 2 weeks of each year.

Now you can see that over the past 10 years, the stock market tends to do well. This suggests that the stock market tends to do better during the week before Christmas rather than the week after Christmas.

Here’s an even looser definition of the “Santa Claus Rally”. This is what the S&P 500 tends to do in the month of December.

As you can see, December is the best month for the S&P 500 (historically speaking).

Here are other ways of quantifying the “Santa Claus Rally”.

This is the S&P 500’s performance during the last week of the previous year (i.e. end of December) and the first week of the new year (i.e. start of January).

Here is the S&P 500’s performance during the last 5 weeks of each year (approximately from Thanksgiving – December 31).

Here is the S&P 500’s performance during the last 6 weeks of each year (approximately from Thanksgiving – December 31).

Conclusion: the stock market tends to perform above-average during December. HOWEVER, this doesn’t mean that the stock market can’t fall in December, as the above statistics have demonstrated. The Santa Claus Rally is a slight bullish tendency, but don’t go long stocks just because “it’s Year End Rally time!”

Sell in May and go away

“Sell in May and go away” is a common phrase that traders and investors use. It refers to the notion that the stock market tends to underperform from May – October and outperform from November – April.

But factually speaking, is it a good idea to “sell in May and go away”?

There are actually 2 versions of this “best 6 months of the year” notion.

As seen in the following chart, the stock market actually does well from October – April, not November – April. Skipping out on October is like leaving money on the table.

Here’s what happens (from 1950 – present):

1. If you buy and hold the S&P 500, $16.66 turns into $2740
2. If you buy and hold only from November – April (i.e. sell from May – October), $16.66 turns into $1340
3. If you buy and hold only from October – April (i.e. sell from May – September) $16.66 turns into $2075.

As you can see, both versions of “Sell in May and go away” underperform buy and hold

Midterm elections

In the Presidential Cycle (4 year cycle, starting from one presidential election to the next), the midterm election years are often the best. The midterm election years refers to the 3rd year of a president’s term in office, starting from the midterm elections.

Here’s what happens to the S&P 500 after midterm elections (during the 3rd year of the Presidential Cycle).

As you can see, the stock market has a strong tendency to go up during midterm election years.

Here’s the S&P 500’s average forward returns for the next 2 years after midterm elections.

Here’s how many describe the stock market’s strong bullish seasonality after midterm elections:

“The stock market tends to be wobbly during the first 2 years of a president’s term because the president is implementing as many of his radical policies as he can, while his party still holds Congress. After the midterm election, the president’s party tends to lose control of Congress, which means that the President becomes a lame duck president. With the President unable to do much, political uncertainties are removed from the stock market, hence the stock market outperforms”.

Whether or not this description is valid is up to you.

Conclusion

As you can see, seasonality is far from being a science. There is not law saying “the stock market MUST go up/down” during a certain season. It is merely a probability, and much of this probability can be attributed to randomness and chance. In a big enough universe, there are always going to be random patterns that exist.

I wouldn’t trade on seasonality factors alone. In fact, my trading models don’t use seasonality. The stock market’s seasonality can break down at any point in time because there is no solid fundamental reason underpinning most of these patterns.

Short term seasonality factors are even less useful than long term seasonality factors.  I often see traders quote statements such as “over the past 30 years, the stock market went up 70% of the time on the last Tuesday of each month”. Trading on such patterns is silly. There is nothing “magical” about Tuesdays that makes them more bullish than other days of the week. Nonsensical patterns break down over time.