Respect the Power of The Calendar

At the start of last week, we called for investors to TAKE PROFITS on their trading positions.

We know many research firms are unwilling to make short-term stock market calls, but we are!

In that note, we shared several data points, and one of those was about seasonality.

Many “serious” investors dismiss it, but successful traders do not ignore it.

To emphasize the point about seasonality, we are sharing a note we wrote a year ago that goes further into the topic. Enjoy and – remember – respect the calendar!

One of the most popular visions of investing is what I would call the "purist" fundamental vision.

The idea is that a stock reflects the sum of a business's cash flows. This means that any movement in the stock price reflects a change in the size and timing of these cash flows.

But anyone who has seen a stock gap down on a random day and then come right back up the next day knows this is nonsense.

This isn't to say that stocks aren't eventually reflective of a business's cash flows. However, that relationship can take a very long time to develop and sometimes may never actually occur.

The enthusiasm of buyers versus sellers drives the short-term move in stocks. I say "enthusiasm" because remember that there are always an equal number of buyers and sellers. There must be one to be the other.

But when one side is more aggressive, you see stock price movements.

Many factors can drive this buyer and seller’s enthusiasm. One of those factors—and one that is often discounted—is seasonality.

I've written several times about seasonality in the past, especially regarding year-end seasonality. This concept asserts itself most powerfully at that time of year, but there's another time of year when it can also be powerful: August through October.

The below charts from Yardeni Research demonstrate what I'm talking about...

Going back more than 90 years, you can see that September is the only month the market has been down more often than it has been up. The market has fallen 55% of the time during the month.

The next-worst month (February) has seen the market fall 48% of the time, and the one after that (June) has seen it fall 43% of the time.

There's clearly something different about September.

And look at the average returns. September is a big outlier, with an average loss of 1.1%. Only two other months show losses, and they are a paltry 0.1% for each.

So, what's happening in September?

One factor is vacations (yes, I'm being serious) ... In the U.S. and Europe, it's normal for folks to take vacations during August and into September.

When money managers are away from their desks, they're more likely to "shoot first and ask questions later." Any volatility may lead them to move to the sidelines.

Another contributing factor is where we are in the calendar year. Remember that most money managers are compensated on year-to-date returns.

When we get to this time of year, they may want to lock in any returns—especially if they're away from their screens and volatility is occurring.

We would like to think that all buy-and-sell decisions are made based on deep, fundamental analysis, but remember, these are still human beings. They act with emotions.

In my view, though, the biggest contributor is something that isn't really discussed: the effect the time of year has on earnings estimates.

Stocks are highly correlated to the earnings expectations. When companies beat expectations, their stocks go up. When they miss expectations, their stocks go down.

Now, think about the estimates that companies put out there...

If you are company management and you're having a tough time meeting your first-quarter estimates, you probably have more room to "fudge" the numbers. It's the start of the year, and there are many accounting methods to help you out. You can also "back-end" load the numbers so as not to decrease your full-year guidance.

If you're still having problems meeting your numbers into the second quarter, you can do some more of the same. You also can blame the summer slowdown.

But by the time you get to third-quarter earnings reports, there really is nowhere to hide.

At this point, if you're going to have to lower guidance for the year, you really need to do it.

This means that third-quarter earnings reports are particularly volatile. If a company knows it needs to reduce its numbers, it is obligated to inform the market before reporting them.

These warnings would happen in... September!

It is hard to say precisely how much of a factor this plays, but it's clear that this time of year is challenging for the market.

Accordingly, with the market at recent highs after a huge run, it makes a lot of sense to consider taking profits and remembering to respect the calendar.