Seasonality can be defined as repetitive and predictable changes in data.As with summer heat and winter cold, the data also have repeating “seasons.”There is seasonality in most datasets, particularly those in the financial and economic sectors. If you look at any government economic statistics, you will see that the headline figure is often “seasonally adjusted” to remove seasonal bias.Here are some practical, common-sense explanations of seasonality before we get into the technical language.Seasonality and predictability are important factors in some items.The consumption of gasoline is seasonal. Travel and outings are more common in summer, so more petrol is consumed. With the exception of volatile events such as global pandemics, this happens every year.
The problem of seasonality in the stock market.
It is true that gasoline consumption is predictable, but that does not mean the future price of gasoline can be predicted. There are so many factors that affect gas prices out of season that betting on just one season would not be profitable.
It is also because we are talking about the season that the real problem with betting on it comes from.
Seasonal patterns can be predicted by traders, and they trade accordingly.
Think about this for a moment.
During the summer season, gasoline costs $2/gallon, instead of $1/gallon year-round. There is a predictable pattern to this every year.
By buying the day before summer begins, smart traders will take advantage of the season. As a result of their early purchase on the day before summer starts, the price will increase slightly. In order to increase the price, smart traders will begin buying two days in advance.
Throughout the year, the price will reflect this event, obviously adjusted for time value of money, and will be iterative until the summer effect is outrun.
People mean this when they say “at a price ”.
In the markets, seasonality can be easily observed, so it is important to keep this in mind. Nevertheless, you can still profit from it, you just need to determine how much the effect is worth and whether the risk/reward is worth it.
All of this makes sense, too. Many people will jump at any opportunity to beat the stock market (provide higher risk-adjusted returns than the broader market) until the edge has been priced in.
Taking advantage of every easy edge on the stock market is like a giant game of chess played by the smartest, richest people in the world.
The Summer Effect: “Sell in May and Go Away”
Stock markets tend to have a weak summer season, which is an old seasonal pattern.
One of the earliest observations of this effect was due to traders realizing that London stockbrokers would take extended summer vacations.
The Wall Street trader and portfolio manager today spends more time and mental energy on their summer adventures in the Hamptons and New England than in their offices.
What is the validity of the “sell in May” strategy? For each month of the year, we can determine this by looking at the average monthly return in S&P 500.
A very observable seasonal pattern can be seen in summer weakness in the stock market.
Holding stock from October to April and selling in May is a very simple way to implement this strategy. The problem with this approach is that you could miss out on strong rallies if you spend approximately half the year out of the market.
In the end, summer weaknesses aren’t a rule, they’re just statistics. It is possible for the stock market to have a very strong summer in any given year, as it did in tech stocks in Summer 2020 for example.
Santa Claus Rally
An annual Christmas present from the stock market is the Santa Claus rally. This is the term used to describe the seasonal outperformance of the stock market during the holiday season.
In order to define the Santa Claus Rally, there is no fixed timeframe.
It is common for some markets to start trading before Thanksgiving and end the day after New Year’s Day, whereas others last much shorter periods of time after Christmas Day, ending the day after New Year’s Day.
This seasonal effect has no clear explanation, but some theories suggest increased investment activity due to year-end tax-related trading or holiday bonuses/gifts. In our business, we don’t look for the cause, but rather exploit these tendencies for profit.
A similar effect can be seen when one sells in May and walks away, however, this only applies to the winter months when outperformance is most noticeable.
Market Holiday Effect
There is a peculiar tendency for the stock market to perform better before and after market holidays. It does not have to be a major holiday, either, as it applies to any market-closed day, such as Memorial Day or President’s Day.
As a general rule, a ‘market holiday’ means the stock market will be closed on that particular day.
The trade involves buying the S&P 500 or the Dow Jones Industrial Average three trading days before the holiday and holding it for three trading days after it.
Stock market seasonal trading is still viewed as a red-headed stepchild, despite its mainstream acceptance in commodities markets.
There is no escaping the seasonality of goods; grain harvests occur during specific periods, gasoline consumption follows established trends, and so forth. On the stock market, it isn’t so clear.
Although seasonality can be hard to find and even harder to explain in the stock market, there’s no doubt it exists.
However, even though a business advantage is more specific and less widely accepted, it is also more profitable.