A Tale of Two Investors

10/01/2002 12:00 am EST

Focus:

Steven Halpern

Editor, thestockadvisors.com

Although he was referring to conflicts in French society at the time of the Revolution, Charles Dickens' opening line of A Tale of Two Cities - "It was the best of times, it was the worst of times..." - could easily apply to today's stock market. Here, we look at a tale of two investors and the possibility that seasonality portends better times ahead.

There is no dearth of reasons for bearishness. Weak consumer spending and a potential housing bubble that could hurt the remaining impetus to spending.  Potential war with Iraq, continued efforts in Afghanistan, turmoil in the Mideast, and rising anti-US sentiment abroad. Rising oil prices, rising gold prices, and a creeping gain in commodity prices. A ballooning deficit. Weak international markets. Fears of deflation. Poor technicals with the market trading near key support levels first set some five years ago.  Virtual devastation in the technology sector with bleak prospects for increased capital spending on the horizon. Weak employment statistics. Ongoing corporate scandals, continued bankruptcies, earnings restatements, a continued loss of confidence by investors in the Wall Street system.  The ongoing fallout in the loss of paper wealth from declining stock prices and the less-discussed impact of falling stock prices on corporate pension accounts. And, of course, the ever-present fear of a future terrorist attack. It is easy to understand why many investors see the market glass as half empty.  Is this "worst of times" scenario a reason to abandon the stock market? Or is it possible that much of the gloom is already factored into stock prices and that "the best of times" may lie somewhere ahead?

Jim Stack, editor of InvesTech Market Analyst, not only excels at analyzing market patterns and historical statistics, but he has an uncanny ability to turn often-arcane technicals into easy-to-understand and straight-forward information. To better understand the effect of seasonality patterns on investors, Jim offers the following Tale of Two Investors:

"For those seeking a reason to believe the glass is half full, historical studies on seasonality should not be ignored. Indeed, we are now in the more favorable half of the four-year election cycle. To understand this cycle, we look at two investors who both start with $10,000.

Investor A buys the S&P 500 index at the midpoint of every off-election year (July 1st) and then sells on the day before the next presidential election. The investor simply sits on his money then, until the midpoint of the off-election year rolls around.

Investor B does just the opposite. He buys the S&P 500 index on the presidential election day (or the day before if a market holiday) and sells at the midpoint of the off-election year.

Now suppose that Investor A and Investor B do this for every election cycle since 1956. What would their respective returns be today? The results are dramatic. Investor B has lost money. His $10,000 starting balance would have declined to $7,911–even though he was invested for almost half the time during the past 45 years. The reason is that many of the bigger bear markets came in the 20 months he was invested after each presidential election.

Meanwhile, Investor A would have seen his same $10,000 increase in value to $239,008–a higher value than a buy-and-hold strategy. Our point is that we have now entered the latter half of the four-year election cycle. We are now in the territory where Investor A made all his profits. Does that guarantee a bull market with big gains ahead? Of course not. But it’s a cyclical factor with strong (very strong) historical precedent. So we should be watching for it in the weeks and months ahead.

We are also not far from entering the bullish seasonality of the year. Past studies have shown the six months from November 1st through April 30th to be far more profitable than the other six months of the year–from May 1st to October 31st. Once again, the results are more visible and dramatic if seen from a tale of two investors.

Investor A buys the S&P 500 index on November 1st, and simply reinvests the dividends until April 30th of the next year, at which point they sell and sit on the money until the next November.

Investor B does exactly the opposite. He buys the S&P 500 index on May 1st and exits on October 31st, to sit and wait in cash until the next May rolls around.

Two investors–both invested exactly six months out of the year–over the past 42 years. But Investor A watches his initial $10,000 investment soar 27-fold to $271,603, while Investor B doesn’t even see his portfolio double. It grows to just $18,626.

Is there some mysterious basis behind this annual seasonality? Perhaps, and it may not be so mysterious. It’s no secret that summer months are dominated by directionless doldrums in the stock market as investors take their summer vacations. This unfavorable period also includes the dreaded Octobers, as well as September–the only month of the year that has seen more losses than gains over the past half century.

But why would November through April be more profitable? Let us count the psychological and money flow reasons: 1) Santa Claus Rally:  the strongest seasonal period of the year is from early December through mid-January; 2) Year-End Prediction:  usually some of the most optimistic, feel-good forecasts of the year; 3) January Effect:  in which small cap stocks see stronger gains than market indexes in general; 4) April 15th Tax Day:  depressing on one hand, but good for the markets as it is also the cut-off date for funding prior year retirement plan contributions. So like the presidential cycle, there are indentifiable reasons for this annual seasonality. Neither work all the time. But it is interesting that both will be in bullish alignment in another few weeks.”

Is this the best of times--offering investors an opportunity to buy stocks at depressed levels before a rebound--or the worst of times--where one's remaining holdings should be sold before a further decline?  Is this, as Dickens noted, "the spring of hope," or "the winter of despair?"

For now, I would caution that the majority of leading advisors continue to focus on downside risks.  And personally, I agree that the potential uncertainties associated with terrorism and war suggest that investors maintain a much more defensive than normal position.  Nevertheless, seasonality strongly suggests that we will experience a significant rally from the next market lows. According to the Stock Traders Almanac, the average gain from a second-year election cycle low to the third-year election high exceeds 50%.  Also adding to favorable seasonality is the fact that since 1946, 13 different bear markets have ended during Octobers.

As Jim Stack notes, "There's plenty that makes us nervous--both from a technical and fundamental standpoint. That is why our portfolios are holding close to 70% in cash. But there's also reason for hope. Bear markets don't go on forever, and this is already the biggest, baddest, longest bear market in a generation. Cyclical factors, like the annual seasonality and presidential cycle, are not reason enough to turn bullish again. Yet, they are a valid basis to keep a watchful eye open for a market bottom."

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