From the October 2006 issue of Investment Advisor • Subscribe!

'Tis the Season(ality)

Calendar-based trading techniques require a nod to the fourth quarter

Attempts to predict the direction of the stock market run the gamut from the sublime to the ridiculous. Besides the usual suspects of fundamental and technical analysis, traders have resorted to astrology, day trading, and other questionable techniques in order to get an edge. This brings us to seasonality, the belief that equities have a tendency to rise and fall during certain times of the year.

Any discussion of calendar-based trading techniques isn't complete without a nod to the fourth quarter, which historically has been the most profitable three-month period to own stocks. As the two charts show, the returns from October to December are significantly more robust than for the other three quarters. Add to that the tendency for stocks to exhibit less volatility during the period, and the result is the beginning of a timing strategy that even the most daunting believer of stock market efficiency would absolutely drool over.

Or is it?

For starters, historical tendencies are just that--predilections that have proven themselves over time. There is no fundamental reason for stocks to rally in the fourth quarter, and certainly there have been times when the last three months have resulted in losses. Although there is some credence to owning stocks in the fourth quarter, there are also ample reasons for owning them the other nine months of the year.

I also have an issue with the consensus view. If everyone expects there to be a fourth quarter rally--and it's hard to find an equity strategist from any Wall Street firm who doesn't--then who will be left to bid up shares if the bulk of traders are busy establishing positions beforehand? We've seen some of this occur so far in September, which every calendar fetishist knows is the weakest month of the year.

Average Quarterly Returns: 1995-2005

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On the flip side of the argument, one must concede that there may be some merit to owning more equities in the last three months of the year. Stock market strength in the fourth quarter is persistent in every ten-year time frame we examined, making its existence hard to refute. The effect is not just present in small stocks, which would potentially make the trade interesting but unpractical, due to high transaction costs. To the contrary, the fourth quarter seems to be better suited for large stocks, making the strategy quite inexpensive to execute.

Among the true believers in the fourth quarter's positive seasonal bias, there are many logical reasons for the trade's success. After all, the fourth quarter contains the two biggest holidays of the year, and folks have been shown to be net buyers of equities during this period. The end of the year is also an important psychological anchoring point for many investors. Perhaps there is a tendency to buy stocks at the end of one year in anticipation of the beginning of a new one. Finally, the bulk of mutual funds end their fiscal year in late September or early October. After selling their losing positions to offset capital gains, these funds could collectively be in a buying mode in the fourth quarter.

I'd advise a bit of caution for those looking to take the plunge this year. Based on our analysis, the best fourth quarters for stocks are often preceded by the weakest third quarters. As a result, one must consider the recent uptick that began in mid-July, which should put 2006's third quarter solidly in the black.

The Puzzler, CIO of Memphis-based Sovereign Wealth Management. Readers can reach him via e-mail at puzzler@investmentadvisor.com.

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