We're skeptical of anyone who claims to be able to pinpoint the underlying causes of market seasonality. Take a look at the most well-known of seasonal effects, the January effect. Here, the standard logic goes, tax-conscious investors punish yearlong losers in December, amplifying these losses, and setting the stage for a January reaction to the overselling. Following this logic, you'd expect stocks with long-term losses and especially low poor performances in December to be the best candidates for the January effect.  However, we've found a simple indicator, unrelated to December or yearlong losses, that has consistently produced a superior list of January effect candidates. What's happening here?

September has been a lousy stock market month for quite a while now. One explanation involves the notion that people simply get depressed when they return to work following their summer vacations. Then again, winter is supposedly the most depressing time of year, so mightn't we expect losses in December and January? On the other hand, there's a tendency for stocks to rise around holidays, supposedly because people are feeling happy and are unusually willing to toss their money around.

There are a number of important finance-related dates in the calendar year. Earnings reports tend to get issued in three-month clusters, although some companies have "offset" fiscal years. There's also April 15, the tax deadline for individuals…while it may be difficult to discern exactly how this date affects the market in the weeks and months thereafter, it's hard to believe that this milestone leaves no ripples on the market whatsoever. Then, we have three-month periods where money managers are expected to file summaries of their performance to their superiors. The theory says that these guys tend to sell their dogs just before their reports are due, to clean up the books and avoid a scolding…after that, they might buy back these losers. 

There is also a six month period from April to November when, according to the folks who have done the studies with over 50 years of data, you'd basically be better off pulling your money out of the market, since almost all gains occur outside this period.  Influx of money from pension funds and bonuses is supposedly responsible for the gain from November to April.

Then there are eclipses, sunspots, planetary conjunctions, whatever. Count us as extreme skeptics when talking about the market effects of these sorts of cyclical phenomena. If, perchance, you do buy into these arguments, the case for seasonality (or, more accurately, cyclicality) is all the stronger.

Most investment methods assume that a particular method should work at all times under all conditions. We find that there are times of year that favor small caps, and other that favor large caps. Bottom-fishing can be quite profitable at times, and will get you slaughtered at others. While investment trends come and go, the yearly financial and psychological milestones stay pretty much the same.   The trick is to get some idea of the market effects of these dates, and take advantage. Pinpointing the exact causes of these seasonal market changes isn't necessarily important or worthwhile.

"Efficient Market Theory" suggests that these trends should be nullified over time.  But is it really so radical to suggest that large numbers of investors have concerns other than optimizing their portfolio returns?  We have institutional managers looking to pretty up their portfolios around quarter's end.  We have every variety of investor looking to minimize the painful effect of taxes at specified times of year.  Furthermore, is it really so crazy to think that the "herd" behavior that occasionally manifests in outrageous (read "inefficient") market gains and losses might be more likely to get sparked at some times than others?

Most studies of seasonality seek to identify the times of year when a rise in the general market is likely or unlikely, given past history.  We take a different tact:  we identify the indicators that have, historically, pointed towards gains or losses in a particular time frame.  

Is such an approach useful?  In one of our historical tests, a portfolio of stocks that attempted to mirror historical monthly trends outgained the Russell 3000 Index by a factor of 6.1 over a span of 10 years.  Another portfolio that buys and sells only at the beginning of quarters, minimizing the effect of commissions, has outgained the Russell 3000 by a factor of 4.8 over 9 years!  Bear in mind that these portfolios typically hold one or two hundred stocks at a time (it's done by computer), so it's essentially impossible for us to "get lucky" and buy a couple of stocks that make a huge difference.  The gains are entirely attributable to analysis of seasonal trends! 

One can only guess how much higher these gains would be when combined with other technical/fundamental methods.  The bottom line:  if seasonality is not incorporated in your investment philosophy, there's a serious gap in your understanding of the market.

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