Trader’s Narrative

This is a guest post by Wayne Whaley (CTA):

I’m not sure whether this market reminds me more of my grandfather’s beagle puppies or the current Secretary of State’s husband, but either way he (the market) doesn’t seem to be inclined to hang around the house for long. It looked like this market might show signs of mean reversion in the second half of October, but then yesterday, it caught wind of the third quarter GDP report and wondered off again, allowing the S&P 500 to post it’s 8th straight up month since the bottom was established in March 2009.

So what’s ahead? A couple of considerations from a seasonal vantage point:

First, since 1950, the average annual return on the S&P 500 index is 8.05%. Over half of that annual return (4.25%) has arrived in the three months November to January.

Second, some respected market technicians have argued that since we didn’t get our usual autumnal sell off, that it may come later in the year. I do agree that the market tends to try to confuse as many of us as possible, but it is very possible the 5% sell off in late October was all we needed to rattle a few cages and I am still inclined to believe that the market’s ability to prevail against traditional seasonal headwinds is a sign of forward strength.

Last month, I posted an article “When September Flexes Its Muscle“, that showed that if the market can manage to post a gain in the seasonally weak September month, the market was has a very high probability of finishing the last quarter positive with an average gain of 4.84%.

Below is a table, with an update of those results for the final two months of the quarter, when both September and October are positive.

Since 1950, the November & December time frame, following up September & October , was 13-2, with a median +6.69% return. If you can allow yourself to consider 1968 to be an unchanged data point (-0.18%), then 2007 was the only noticeable loser in the 15 data points. Under the theory, when the market goes against the seasonal trend - go with the market, the 2007 data point provided strong clues as to what was to come in 2008.

There is a meaningful pullback coming. And staying long for the well known, traditionally strong, year end rally almost seems too logical. But I think that given it has been eight in a row with the holidays to go (rhyme intended), we are well advised to stay with the trend at least through January of 2010 or until the tape shares some information with us to the contrary.

Those of you who follow my commentary know that I am also influenced by the three strong breadth thrust “The Mother of All Momentum Thrust Years” we had this year, the last coming in September. However, if the year end rally doesn’t materialize (ala 2007), one would be well advised to take some defensive measures.

Good luck to us all.

Apologies for the late posting so far this week. I was away at a family wedding and missed the regular scheduled posts.

Brace yourself because we are about to enter the best months of the year for the stock market. This seasonality pattern is most commonly called the “Halloween indicator” and lasts from November to April - where most of the returns have tended to originate historically.

But this year was atypical in that we had a spectacular rally early in the year. In fact, this was arguably the most hated rally since very few purportedly believed in it or predicted it. And yet it happened. In any case, seasonality patterns should not be confused with blueprints. They are merely loose fitting guides to be draped over price action. The stock market certainly does not heed them every cycle.

According to Mary Ann Bartels, a technical analyst ranked second by Institutional Investor magazine, the weakness we should have seen may simply be delayed, rather than skipped outright. Here is a chart comparing the S&P 500 so far this year, compared with the other instances where seasonality was turned upside down:

Source: Bloomberg

While Bartels is looking forward to a correction to end the year, she does expect that to set up a base for further gains next year. She expects the S&P 500 to reach 1325, a further 22% rise from here.

Diligent readers will recall a historical study provided by guest writer, Wayne Whaley where 7 consecutive months of positive return have a surprisingly bullish bias going forward. October isn’t over obviously but with a 3.21% return (so far) we are set for a continuation of the short term strength that defies the intuitive expectation of ‘mean reversion’ after so many positive months.

Forget everything you know about the market. If you have a long enough time horizon, all you need is a calendar.

More specifically:

1. Look at the calendar
2. From May to October, stay out of the market (or go short).
3. From November to April, buy or go long.

That’s it.

Forget technical analysis. Forget fundamental analysis; watching talking heads on TV; reading blogs (cough). Or anything else.

The only catch is that you have to have time on your side. Because each and every single instance is not going to go in your favor. But on average, you’ll be far ahead of a simple buy and hold strategy.

For some strange reason, winter months are great for stock market returns and summer months are bad. This holds true across time as we go back decade after decade, it also holds true if we go across the globe and look at different stock markets in different countries.

This is known by a few names: Sell in May and go away, Halloween indicator, winter months good, summer months bad, etc. Theoretically this pattern should not exist. But it does. And it bothers a lot of economists. Most of them would rather not think about it so they just shoo away this and similar holes in the EMH.

Fact is that the Halloween indicator, like election year pattern, the January effect, 4 year cycle and many others, present not one but two challenges to EMH. One, they should not exist if the market is as economists theorize, “efficient”. Two, if they did exist, they shouldn’t persist, which they do. That is to say, if they do exist, which they shouldn’t in the first place, they certainly shouldn’t continue to exists year after year, decade after decade because theoretically, people would wise up and by taking advantage of it, remove it from occurring.

Neither of these is true, of course.

Probably the definitive report on this anomaly was published Ben Jacobsen and Sven Bouman. You can read their working paper from July 2001 in the free trading resource section (Reports & Articles).

They not only look at the pattern of stock market returns, they turn over every stone looking for an explanation. They can’t find any. But they do have some interesting things to say nonetheless:

Based on the old market saying Sell in May and go away (or the Halloween indicator), we find that there is a substantial difference between returns in the period May-October and the remainder of the year. In fact our evidence shows that while during the period November - April returns are large in most countries, average returns in the period May-October are not significantly different from zero and are often even negative.

We found that in many countries the Sell in May effect cannot be a January effect only.