Profiting from Monthly Seasonality in the Stock Market
Here's some research that should get your attention. Assume two portfolios — which we'll call the Green and the Red—were started in January 1927. Although the market is open, on average, about twenty-one days each month, the Green portfolio was invested in common stocks only during a certain "favorable period" of seven days that recurs each month. Then the stocks would be sold and the Green portfolio would be invested in Treasury bills until the next favorable period rolled around.
The Red portfolio, on the other hand, was invested in the opposite fashion, owning stocks only during the 14 or so other days each month, the days when the Green portfolio was sitting on the sidelines. Think of this as an "unfavorable period." Both started with $1,000, and continued their crazy competition down through the decades until 1990 (which is as far as the original research went) when they totaled up their gains from 64 years of investing.
The Green portfolio, which was invested only one-third of the time, grew to a staggering $4,400,000! And the Red portfolio, which was invested twice as many days each month as the Green, saw its original $1,000 shrink to a meager $433! (Commissions and taxes have been omitted to dramatize the point.) Pretty amazing, huh? I first read of the existence of a monthly favorable period in the late 1970s in a book called Stock Market Logic, by Norman Fosback, who did the pioneering work in popularizing its acceptance as a timing tool. He called it "seasonality," and defined it as (here's the part you've been waiting for) the last two trading days and first five trading days of each month.
In 1990, the scholarly Journal of Finance published a paper by Joseph P. Ogden of State University of New York. He has offered an explanation of why there seems to be recurring buying activity at certain times of the month that drives the market higher. Professor Ogden's research discovered that 45% of all common stock dividends, 65% of all preferred stock dividends, 70% of interest and principal payments on corporate bonds, and 90% of the interest and payments on municipal bonds, is paid to investors on the first or last business day of each month. All this is in addition to the month-end contributions from salary checks that have been predesignated to go into various stock purchase plans. What do investors do with all this money? Dr. Ogden thinks they put a sizable portion into the stock market, thus accounting for a significant part of the turn-of-the-month phenomena.
Yale Hirsch, publisher of the Stock Trader's Almanac, believes the growing awareness among investors of the monthly favorable period caused it to change beginning in the mid-1980s. As more investors tried to get in ahead of this monthly rally, it had the effect of causing the rally to begin sooner. Hirsch says the pattern has been altered so that the "new seasonality shifted to the last four trading days of the previous month and the first two of the current month."
Who's right? For the investor using a monthly dollar-cost-averaging strategy, it doesn't matter. (Dollar-cost-averaging is the practice of investing the same amount of money at regular time intervals, usually monthly.) Just do your buying before the other month-end investors start theirs, say with at least five trading days remaining in the month. Then, whether the Hirsch theory (seasonality begins with four trading days remaining in the month) or the Fosback theory (seasonality begins with two trading days remaining in the month) is correct, you'll still benefit from the buying that surrounds the turn of the month. Remember, the value of this strategy manifests itself over the long haul—it won't work as expected every month.
For example, the last seven days in September fall as follows: 24th Wednesday, 25th Thursday, 26th Friday, 27th Saturday, 28th Sunday, 29th Monday, and 30th Tuesday. Since the financial markets are closed on the weekends, the final four trading days in September will be the 25th, 26th, 29th, and 30th. In that event, you would want to make your investment the day before the 25th—on Wednesday the 24th. If you have your money at a fund organization or broker, a timely phone call or click of the mouse will transfer it into your stock fund on the day of your choosing each month.
If you've set up an automatic transfer which is executed on the same date every month, you give up a little precision because the seasonal period varies from month to month depending on where weekends fall and the number of days in the month. In that case, I would probably choose the 24th of the month. That date will be on target most of the time during months that have 30 days, and a little early in months other than February. This will be close enough to still provide a benefit.
Here are a few other ways you can use monthly seasonality to improve your long-term performance.
Perhaps you're in retirement and part of your income derives from selling enough of your growth fund each month in order to withdraw $500. Wait until the favorable period has run its course; sell your shares on the fifth trading day of each month (or a few days earlier if observation persuades you that Hirsch is correct). A refinement of this takes into account that Friday has a tendency to be a strong market day; therefore, if the fifth trading day of a particular month falls on Thursday, wait one more day and sell on Friday instead. Over the long-term, you'll get a slightly better average price.
On a variation of the dollar-cost-averaging strategy, use favorable periods when investing a windfall (for example, an inheritance). If you haven't been investing regularly, it's a little scary to take a large sum and put it into the market "all at once." Divide it into several smaller amounts of equal size, depending on how long you want to stretch things out. For example, if you wanted to invest it over a period of six months, divide your total into six equal amounts. Then invest one-sixth each month just before the start of the favorable period.
The monthly seasonality concepts also work well in conjunction with the annual seasonality strategy explained on our SMI Advanced Strategies page.
Remember, these patterns are not perfect. The seasonality studies reflect "averages." By definition, an average finds the middle ground (and therefore hides the extremes). So don't expect the favorable period to lead to higher prices every month. Along with J.P. Morgan, the only thing we know for sure about next month's market is that "stocks will fluctuate." Seasonality should only be used as one piece of an overall decision-making process.
© Sound Mind Investing
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Originally published September 11, 2008.
