Thursday, October 31, 2013

The Best Six Months Start Now

The end of the "worst 6 months" in the stock market is upon us. Tomorrow is November 1, when seasonality turns positive.

We last wrote about seasonality in April. Our bottom-line was this: May to October is less bad than you think (post). Median returns since 1970 on SPX are 8% during winter (November to April) and 4% during summer (May to October). "You might sell in May and buy back higher in November."

This summer was exceptionally strong: since May 1, SPX is up almost 11%. This puts it in the top 17% over the past > 40 years.

Below are the SPX returns by season since 1970. Summers are red and winters are blue. The arrows show returns in the summer of over 10%.

What to expect in the month's ahead? Normally, a very good return.

Almost half (48%) of winters produce a return of 10% or more. This seasonal factor is so strong that great returns are almost three times as likely to take place in the winter as the summer.

When summer has produced a return over 10% (like this year), winter has been positive 6 out of the last 7 times. Look again at the chart above; the sole exception was 1989. Not including drawdown, none of the winters following a strong summer has produced a large net loss. In the chart below, the large net losses in winter (only 4 of them) have all occurred after a relatively weak summer.

Mark Hulbert reached the same conclusions when looked at over the past 50 years. "There have been 15 occasions over the past 50 years when the S&P 500 gained as much during the summer as it has this year. That strength has tended to persist into the subsequent winter period — resulting in an average S&P 500 gain of 9.6% between Halloween and May Day (article)."

November, December and January are the strongest three month stretch of the year:

This seems to be a compelling backdrop for equities. What could go wrong?

The most obvious is this: SPX is up 40% in the past 2 years. Refer to the first chart above: 6 out of those 7 strong summers came near a low in the market (1997 is the sole exception). That is not the current set up. With fund flows into equities reaching the highest level since 2000, it's more than possible investors have front run positive seasonality.

The chart below looks at equity exposure among active managers, with the arrows placed at the end of October of each year. Not only is the current equity exposure at the 4th highest ever, but you could also say that never has a year-end rally been so widely anticipated.

The other watch out is this: Year Two of the Presidential cycle is the weakest of the four. Over the next 12-months, equity returns are typically flat (green arrow). This is the year when Congress bickers ahead of mid-term elections and the Executive Office takes economic hits to ensure a positive environment ahead of the next presidential election.