Seasonal Investing

 

 

What does seasonal investing include?

 

By definition, seasonal investing includes:

  • A start date for an investment
  • An end date
  • Either price strength or weakness between the start and end dates for the chosen equity, sector, index or commodity.

 

A seasonality study preferably uses at least 10 years of data. However, data may not always be available for 10 years. Studies using less than ten years of data can be used, but they tend to be less reliable. Results of shorter term studies have a higher chance of being skewed by a single data point.

 

Results using at least ten year of data tend to be stable for long periods of time, particularly when annual recurring fundamental reasons causing seasonality are unchanged. However, “statistical” slippage can occur. For example, the U.S. high tech sector has a period of seasonal strength from the end of September to a time between the end of December and the end January. On average, the sector peaks between start of the annual Las Vegas consumer electronics show in the second week in January and start of fourth quarter earnings reports near the end of January. Optimal time to own high tech securities for a seasonal trade based on month end statistical data over a 10 year period frequently flips back and forth from the end of December to the end of January. Seasonality studies on equity indices, sectors and commodities need to be re-examined once a year to see if slippage has occurred.

 

Time length for most periods of seasonal strength or weakness ranges from five weeks to seven months. Special short term periods often related to holidays also have been identified. Examples include strength just before and after U.S. Thanksgiving and strength from just before Christmas to just after the New Year.  Also, longer term “cyclical” periods lasting several years have been identified. Most notable is the four year economic or “presidential” cycle. Data for longer term cyclical periods frequently can be overlaid with annual data to refine seasonal entry and exit points.

 

Some sectors and commodities have more than one period of seasonal strength. A good example is the Canadian financial services sector. Its periods of seasonal strength are from the end of September to the end of December and from the end of February to the end of May. Investors frequently will combine the two periods rather than sell at the end of the first period and repurchase at the beginning of the second period, particularly when the time between the two periods of seasonality is relatively small. In this case, many investors will choose to own the financial services sector from the end of September to the end of May. Traders with a shorter time horizon may choose one or both periods based on fundamental and technical considerations.

 

Most periods of seasonal strength are NOT followed by a periods of seasonal weakness. In most cases, periods of seasonal strength are followed by a period of random performance. Markets moving from a period of seasonal strength to a period of seasonal weakness are rare, but can occur. One of those rare markets is lumber. Seasonal strength occurs from the end of September to the end of January and seasonal weakness occurs from the end of January to the end of September.

 

Measuring Seasonality

 

Seasonality is measured in three ways:

  • Average return during the chosen period expressed as a percent
  • Reliability expressed by the number of profitable periods out of at least the past ten periods.
  • Performance relative to a major equity index such as the S&P 500 Index or the TSX Composite Index.

 

A seasonal investment by definition is profitable more than 50% of the time. If only 50% of the trades are profitable and 50% are unprofitable, results are random. Confidence in a seasonal trade increases with the frequency of profitable trades. A confidence level for a seasonal trade exceeding is 70% is preferred. A confidence level of 80% frequently is available. A confidence level of 90% is relatively rare. A confidence level of 100% is extremely rare.

 

Primary Factors Influencing Seasonality

 

Seasonality happens because of a series of annual recurring events. The job of a seasonality analyst is to examine if the annual events are likely to recur prior to a period of seasonal strength. If annual recurring events are less likely to occur, the seasonality analyst will avoid recommending a seasonal trade.

 

The classic example is a series of recurring events that trigger the annual period of seasonal strength in the Canadian equity market.  The TSX Composite Index has an historic period of seasonal strength from the end of September to the end of April. The strategy is known as the “Buy when it snows, sell when it goes” strategy: Canadian equity markets start to move higher near the end of September when the first snowfalls frequently appear in many parts of southern Canada. Equity markets tend to reach a seasonal peak near the end of March/ middle of April when last of the snow melts away.

 

 

Seasonality by the TSX Composite Index occurs mainly due to a series of annual recurring, tax-related events:

·        The TSX Composite Index tends to reach a seasonal low in late September/October when year end tax loss selling swells. Selling is completed by private investors who are looking to offset gains realized earlier in the year. In addition, institutional investors (most notably mutual funds) are looking for ways to become more “tax efficient” prior to year end.

  • The October/November period corresponds with the reporting of third quarter earnings when fundamental analysts frequently “bite the bullet” on optimistic earnings estimates for the current year. In addition, analysts frequently will roll out estimates for the following year at this time. Net result is that estimates frequently are reduced and target prices frequently are cut during this period.
  • Equity markets move higher as year-end approaches. Selling pressures for tax reasons are relieved near the end of December. Stocks under pressure due to tax loss selling become top candidates to purchase if their fundamental and technical prospects are encouraging. The stage is set for the traditional “Santa Claus rally” Also, investor sentiment tends to influence equity markets favourably during the “Santa Claus rally” period: Many institutional investors “close their books” for the season just prior to Christmas and don’t return until near the end of the first week in January. Their influence on equity markets is greatly diminished. Individual investors have a greater than normal influence during this period and they tend to be in a buoyant holiday mood. In addition, this is the time of year when individual investors are encouraged by investment advisors and mutual fund companies to buy equities. Research departments at most investment firms crank out glowing reports about investment prospects for the following year. Frequently, the reports are accompanied with a list of top equity picks for the following year.
  • Equity markets move higher in January and February due to money flows from two sources. In early January many employees receive annual bonuses. At least some of their bonuses are invested into equity markets. The biggest money flow source during the January/February period is contributions into Registered Retirement Savings Plans (RRSPs). Canadian investors have 60 days from the end of the year to contribute funds into an RRSP. Contributions are eligible for a tax deduction against employment income from the previous year. The investment community is fully aware that many Canadian investors tend to defer contributions into an RRSP until near the end of February. Annual financial service shows and marketing programs by the financial services industry tend to peak in February.
  • Equity markets continue to move higher into March/April as contributions into RRSPs eventually are invested into equity markets. When money flows eventually dissipate, the period of seasonal strength ends.

 

Similar annual recurring tax related seasonal events also influence U.S. equity markets: Tax loss selling appears near the beginning of the fourth quarter.

  • Fundamental analysts re-evaluate earnings estimates for the current and next year and revise their target prices after third quarter results are released.
  • Tax loss buying of stocks depressed by tax loss selling occurs near the end of December when trading for the following tax year starts.
  • Individual U.S. investors have an impact on equity markets during the Santa Claus rally period. They are in a buoyant mood. In addition, bullish year end investment reports by investment dealers encourage equity purchases.
  • Annual employee bonuses received in January further enhance investment into equity markets.

 

Annual recurring tax-related events influencing seasonal trades are slightly different in the U.S. and Canada:

·        401 K plans in the U.S. are similar, but not as tax effective as RRSPs in Canada. Both plans allow tax free accumulation of investment returns within their plan. Both have restriction on the size of their annual contribution. The main difference is that contributions into an RRSP are tax deductible while contributions into a 401 K plan are not tax deductible.

 

·        Most U.S. mutual funds have a year end at the end of October whereas most Canadian mutual funds have a year end at the end of December. Mutual funds like to “clean up” their equity portfolios prior to their fiscal year end. The practice is known in the investment community as “window dressing”: Underperforming equity holdings are sold and replaced by better performing holdings. Net impact is a brief period of seasonal weakness in U.S. equity markets just prior to the end of October and a brief period of seasonal weakness in Canadian equity markets in the first half of December.

 

Several non-tax related events favourably influence U.S. and Canadian equity markets during the January to April period. Chief executive officers love to offer encouraging news when fourth quarter and annual results are released in January/early February. Earnings reports are followed by two more opportunities for CEOs to offer encouraging news: annual reports in February/March and annual meetings in April/early May.  

 

Annual recurring events also impact other world equity markets. The London FT Index and the Nikkei Index have a similar period of seasonal strength. The period of seasonal strength for the London FT Index is from the end of October to the end of April. The period of seasonal strength for the Nikkei Index is from the end of October to the end of March.

 

Annual seasonality in equity markets has a direct influence on the seasonality on all sectors with the possible exception of the gold sector. Seasonality in the gold sector tends to be contra-cyclical to seasonality in world equity markets.

 

Securities Suitable for Seasonal Equity Investing

 

Security suitability depends on the knowledge level achieved by the investor:

 

Investors with the least amount of investment knowledge should focus on Exchange Traded Funds (ETF) that track the seasonality of well known equity indices and sectors. A wide variety of ETFs currently are available. Over 690 ETFs currently are listed on North American exchanges. ETFs hold a basket of equities that track an index. Reasons to own ETFs include their diversification, low cost, tax efficiency and ease to buy and sell. Better known Exchange Traded Funds include DIAMONDS (i.e. Dow Jones Industrial Average tracking units), SPYDRS (i.e. S&P 500 Index Deposit Receipts), Qubes (i.e. NASDAQ 100 tracking units) and i60s (i.e. TSX 60 Index units).

 

Investors with access to reliable fundamental analysis sources can choose individual equity securities that track a period of seasonal strength. Top choices are individual equities with encouraging news making potential during the period of seasonal strength.

 

Similarly, investors with access to reliable technical analysis sources can choose individual equity securities that are developing favourable technical patterns during a period of seasonal strength.

 

Investors with greater investment knowledge can apply sophisticated strategies including various conservative listed option strategies that tie into periods of seasonal strength. Possible listed option strategies include:

·        Covered call writes (i.e. the purchase of a favoured equity security or ETF and the simultaneous sale of listed call options). Covered call writes are the preferred conservative option strategy for seasonal investors. Equity positions are purchase at the beginning of a period of seasonal strength and appropriate calls are sold against the positions with expiry at the end of the period of seasonal strength. Net result: equity positions on a successful seasonal trade automatically are liquidated at the end of the period of seasonal strength.

·        Cash secured put writes (i.e. the sale of put options against a cash equivalent position that is sufficient to purchase the equity security or ETF.

·        Synthetic stock positions (i.e. the simultaneous purchase of call options and sale of put options while holding a cash equivalent security that is sufficient to purchase the stock).

·        Portfolio insurance (i.e. the purchase of put options against an equity security, ETF or equity portfolio).

 

Generally, a seasonal trade with mutual funds is not recommended. Most mutual funds are more costly, less profitable and less tax efficient than Exchange Traded Funds or a basket of individual equities. In addition, liquidity is an issue. Most mutual funds dissuade investors from buying and selling within a 90 day period. Exceptions exist: Mutual funds are preferred when a chosen sector is not well represented or is imbalanced in an Exchange Traded Fund.

 

Combining Seasonality with Technical and Fundamental Analysis

 

Using seasonality as a “stand alone” tool to make investment decisions is NOT recommended.  Seasonality is a useful analytical tool, but only when used in conjunction with fundamental and technical analysis. Trades based on seasonality alone are profitable in say seven or eight times out of 10, but are unprofitable in two or three times out of ten.

 

The same can be said for investment based on technical analysis. Reliable technical patterns such as head-and-shoulders patterns are accurate approximately 75% of the time. However, they are not accurate 25% of the time.

 

Trades based on fundamental analysis alone also are not recommended. Fundamental analyst picks may be profitable most of the time. However, results from a stock picking contest during 2006 run by the Globe and Mail showed that even the best fundamental analysts are far from perfect. The contest requested each participant to choose one stock to buy at the beginning of 2006 and to hold until the end of the year. Participants included a college student, a financial journalist and seven of Canada’s top fundamental analysts. You guessed it! The winner and only person to choose a stock that appreciated in 2006 was the college student.

 

Chances of a choosing a profitable seasonal trade are greatly enhanced if all three methods of analysis are combined. Of equal importance, chances of losing capital are greatly reduced.

 

Seasonality analysis is the bridge between fundamental and technical analysis:

  • Fundamental analysis tells us what to buy and sell
  • Technical analysis tells us when to buy and sell.
  • Seasonality analysis tells us what and when to buy and sell.

 

A word of caution when using seasonality for equity trades! Entry and exit points based on seasonality studies rarely are precise. A low point for entry into a seasonal trade and a high point for exit rarely happen on the precise day each year. Seasonality studies provide an approximate period for entry and exit and are used for statistical purposes when determining frequency and profitability of a seasonal trade. Frequency and profitability of seasonal trades usually can be greatly enhanced by using a combination of seasonality and technical analysis to determine entry and exit points. An investor using seasonality analysis will look for entry points based on short term momentum indicators as the month of seasonal strength approaches. A wide variety of technical indicators are available including Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD) and Stochastics. Choice of momentum indicators is determined by the investor.

 

Identifying Seasonal Trades

 

Several methods are available to identify periods of seasonal strength:

  • Comments on seasonality made by fundamental analysts can be confirmed by completing a seasonality report based on data for 10 years or more. Fundamental analysts are notorious for commenting on seasonal trends based on 2-5 year data. Ten year studies will confirm or not confirm their comments. A few fundamental analysts on Bay and Wall Street are well aware of long term seasonal trends and base the timing of their recommendations at least partially on seasonality. They usually are analysts who have been in the financial service industry for 10 years or more. 
  • Recurring spikes can be examined on monthly price charts using 10 or more years of data. Recurring spikes at the same time each year either on the upside or downside can suggest the possibility of a seasonal trend.
  • Companies and sectors can be examined when they have at least one quarter per year when revenues, earnings, cash flow and/or Earnings Before Interest, Depreciation and Amortization (EBITDA) are seasonally strong. Examples include retail merchandising and consumer electronic companies in the fourth quarter or airline companies in the summer. Seasonal strength in their share price normally begins just prior to their period of seasonal financial strength and ends just prior to the end of their seasonal period of financial strength.
  • Data for 10 years or more can be screened to identify equities and sectors showing periods of above average strength relative to their benchmark index. Preferred benchmarks are the S&P 500 Index for U.S. equities and sectors and the TSX Composite Index for Canadian equities and sectors.

 

Seasonality Myths

 

One of the greatest myths on Wall Street and Bay Street is that North American equity markets usually experience a “summer rally”. Traders frequently start talking in May about the possibility of a rally in the stock market in the June to August period. Talk by traders normally escalates during a period when North American equity markets are experiencing a short term correction. The message is “Don’t worry, be happy. The market will come back”.  A long term study of the TSX Composite Index and S&P 500 Index confirms that a rally lasting three weeks or more inevitably happens during the three month summer period. However, traders fail to mention that the three week rally period has no consistency. Timing of the appearance of the three week rally is random and can appear at any time during the three month period. Of greater importance, traders fail to mention that virtually all three month periods during the year record at least one period of recovery lasting three weeks or more regardless of season.

 

Another myth is the expression “Sell in May and go away”. The myth originated from an actual period of seasonal strength in the base metal sector. Base metal prices as well as base metal equity prices tended to peak early in May and bottom near the end of September. The main reason was the annual operating shut down by base metal smelters in Europe in July and August for Europe’s extended holiday season. Demand by smelters for base metal concentrates slowed in May and recovered in September. Currently, base metal prices continue to show this seasonal pattern, but the pattern has been muted over the years. Market share of base metal smelter capacity in Europe has declined while market share in the Far East and South America has increased. Over the past decade, the “Sell in May and go away” phrase became adopted by the media, but with a slightly different twist. The phrase was transformed into expectation for weakness by broadly based North American equity indices such as the S&P 500 Index and the TSX Composite Index from the end of May to the end of September. The myth is not supported by fact. The S&P 500 Index and the TSX Composite Index has gained in five of the past ten periods from the end of May to the end of September. Unlike the period of seasonal strength by North American equity markets from the end of September to the end of

April, performance in the May to September period is random. This period does not have a sufficient number of annual recurring events to influence equity markets. 

 

Another myth is that the month of October is a weak and dangerous month for North American equity markets. The myth is based on the fact that substantial downdrafts in North American prices have occurred in the month of October. October 1929 and October 1987 are seared into the minds of traders. However, data during the past ten years suggests that fears of weakness in October no longer are founded. The S&P 500 Index has advanced in five of the past 10 periods and the TSX Composite Index has gained in seven of the past 10 periods. On the contrary! October frequently is the month of the year when important seasonal lows frequently are reached.

 

Identified Periods of Seasonal Strength for Equity Indices, Equity Sectors, Industrial Commodities and Selected Stocks as of June 1st 2008

 

S&P Sector     Period of Strength      Average Return Per              # of Profitable

                                                            Period (Last 10 Periods)        Trades out of 10

Energy              End of October

                        To end of May               12.9%                                    9

Industrials         End of September

                        To end of December        6.5                                        8

Information       End of September        

  Technology     To end of January         10.1                                        8

Telecom           End of August

                        To end of December        6.7                                        7

Consumer         End of September        

   Discretion      To end of December        8.2                                       8

Consumer         End of September                                            

   Staples          To end of December        6.8                                        9

Financials         End of September        

                        To end of December        5.0                                        9

Health Care      End of August

                        To end of December        5.1                                       8

Materials          End of September           

                        To end of April             12.6                                        9

Utilities             End of February             

                        To end of May               5.5                                         8

 

Exchange Traded Funds are available on all of the above sectors.

 

Following is seasonality for equivalent Canadian sectors:

 

TSX Sector     Period of Strength      Average Return Per              # of Profitable

                                                            Period (Last 10 Periods)        Trades out of 10

Gold     **        End of July

                        To end of September    11.1                                         8

Energy  **        End of November        

                        To end of May             19.4                                         10

Information**   End of October

   Technology    To end of January         14.3                                         7

Consumer         End of October

   Staples          To end of May               6.7                                         8

Health Care      End of November

                        To end of February         7.9                                         6

Consumer         End of September                                                      

   Discretion      To end of May               7.3                                         9

Financials**     End of September        

                        To end of May               8.8                                         9

Industrials         End of September

                        To end of May             13.3                                        10

Telecom           End of September        

                        To End of January           9.6                                        9

Utilities End of July

                        To end of December        6.2                                          8

Materials**      End of September          

                        To end of February       12.2                                           8

 

** Exchange Traded Funds are available.

 

Index Seasonality

 

Index               Period of Strength      Average Return Per              # of Profitable

                                                            Period (Last 10 Periods)        Trades out of 10

Nikkei Index    End of October            4.30%                                      7

            **        To end of April

                        End of April                  (5.35) %                                  3

                        To end of October       

London FT       End of September         6.10%                                      8

            **        To end of April

                        End of April                  (5.48) %                                  4

                        To end of September

Paris CAC       End of September         10.08%                                    7

            **        To end of April

                        End of April                  (5.36) %                                  4

                        To end of September

FrankfurtDAX  End of September         12.17%                                    8                     

            **        To end of April

                        End of April                  (7.80) %                                  3

                        To End of September

S&P 500          End of September         5.94%                                      8

            **        To end of April

                        End of April                  (3.32) %                                  5

                        To end of September

Dow Jones       End of September           7.53%                                    9

Industrial          To end of April

Average **      End of April                   (3.66) %                                 3

                        To end of September

Dow Jones       End of September         15.58%                                    9

Transportation  To end of May

Average **      End of May                  (8.18) %                                  5

                        To end of September

TSX                 End of September         7.64%                                     8

            **        To end of April

                        End of April                  (0.59)%                                   4

                        To end of September   

NASDAQ        End of September         10.12%                                    7

            **        To end of January        

                        End of January              (6.14)%                                   5

                        To end of September

Philadelphia      End of September         17.04%                                    8

Semiconduct     To end of February      

(SOX)              End of February           (14.03) %                                3

            **        To end of September

Philadelphia      End of July                     9.02%                                    8

Gold &Silver    To end of September

                        End of September           2.65%                                    5

                        To end of July

Amex               End of July                   12.51%                                    8

Gold Bug          To end of September

                        End of September           2.43                                       6

                        To end of July

Amex               End of July                   11.07%                                    9

Biotech **        to end of December

                        End of December           1.85%                                    4

                        To end of July

Russell 2000     End of Sept.                  8.60%                                     9

            **        To end of January

                        End of January              (3.79) %                                  4

                        To end of Sept.           

PHLX  **        End of November         22.89%                                    10

Oil Service       To end of May

                        End of May                    (4.31) %                                4

                        To end of November

U.S. Broker     End of August                 13.56%                                  7

Dealers **        to end of January

                        End of January                    (0.43) %                            4

                        To end of August

** Exchange Traded Fund available

 

Industrial and Precious Metal Commodity Seasonality

Commodity     Period of Strength      Average Return per               # of Profitable

                                                            Period (Last 10 periods)        Trades out of 10

Gold     **        End of July                   6.8%                                        8

                        To end of September   

Silver    **        End of September         22.3%                                      7

                        To end of February

Copper            End of October            18.0%                                      8

                        To end of March

Aluminum         End of September          12.1%                                     8

                        To end of February      

Lumber            End of October            11.9                                         9

                        To end of January        

Gasoline           End of January              23.5                                         9

                        To end of April

Alberta             End of July                   39.6                                         6

Natural Gas**  To end of December    

U.S.                 End of July                   24.9                                         9

Natural Gas**  To end of October       

** Exchange Traded Fund available

 

 

Selected Stock Seasonality

Stock               Period of Strength      Average Return per               # of Profitable

                                                            Period (Last 10 periods)        Trades out of 10

Cameco           End of July                   18.4%                                      6

                        To end of February      

Denison Mine   End of July                   45.2%                                      8

                        To end of February

Barrick Gold    End of July                   11.8%                                      8

                        To end of September

Newmont         End of July                   10.5%                                      8

                        To end of September

Deere               End of June                  12.4%                                      8

                        To end of December

Potash Corp.    End of June                  42.0%                                      8

                        To end of December

Agrium             End of June                  25.3%                                      8

                        To end of December

Weyerhaueser  End of October            11.1%                                      9

                        To end of April

West Fraser     End of October            16.3%                                      9         

                        To end of April

Int’l Forest Pr.  End of October            19.3                                         8

                        To end of April

Canfor              End of October            24.3                                         9

                        To end of April

 

Selecting Periods of Seasonal Strength in Sectors Based On Identified Annual Recurring Events

 

U.S. Energy

  • Strongest quarter for cash flow and earnings: First quarter
  • Influenced by favourable seasonality in the price of crude oil and natural gas from February to May and by favourable seasonality in natural gas from August to December.

 

Information Technology

  • Strongest revenue and earnings quarter: fourth quarter in response to consumer electronic sales prior to Christmas
  • Climax often associated with the Las Vegas Consumer Electronic show in the second week in January

Telecom

  • Strongest revenue and earnings quarter: fourth quarter

 

 

Health Care

·        Key health care conferences usually are in September (Oncology conference) and January (JP Morgan health conference). The sector has a history of reaching a seasonal peak when the JP Morgan health care conference is held in mid January.

·        A higher frequency of drug approval in the U.S. usually occurs just prior to year end

 

Philadelphia Semiconductor (SOX)

·        Strongest quarter: fourth quarter in unison with consumer electronic sales during the Christmas season.

·        Peaks frequently occur shortly after the Las Vegas consumer electronics show.

 

Philadelphia Gold and Silver (XAU)

·        Strength in the July to September period corresponds to strength in gold. Gold strengthens when gold fabricators are buying gold to make jewelry for the Christmas and Dhaliwal seasons.

·        Gold stocks and ETFs tend to be contra-cyclical. They move higher during periods of stock market weakness (particularly in summer months).

 

Amex Biotech (BTK)

·        Key healthcare conferences in September (Oncology conference) and January (JP Morgan health care conference).The sector tends to peak just after the JP Morgan health care conference in midJanuary.

·        A higher frequency of FDA drug approvals just prior to year end.

 

Philadelphia Oil Service

  • Tracks crude oil and unleaded gas price trends
  • Frequently peaks in mid May when the Offshore Technology Conference is held.

 

Events influencing Canadian sectors are virtually identical with events influencing U.S. sectors. The exception is the Canadian health care sector. This sector is heavily weighted in one stock, Biovail. Investors are reminded that Canadian sector indices frequently are influenced by a heavy weight in one or two stocks.