Stocks: Still Higher in the Fourth Quarter

Investing Daily Article of the Week

by Ari Charney, Contributing Editor, Investing Daily

The market’s bottom during the Great Recession may have occurred well over three years ago, but most investors are still behaving as if the next downturn is imminent. That’s an understandable mentality when one considers both the depths to which the market dropped during the downturn, as well as the sharp selloffs that have punctuated each of the subsequent calendar years. Investors are still clearly working through the psychic damage they suffered during the financial crisis.

Although the S&P 500 has produced a dividend-reinvested return of almost 104 percent since March 2009, its long slog to four-year highs has hardly felt like a traditional bull market. And at this juncture, one might reasonably wonder if we’re closer to the end of the market’s upward ascent than the beginning.

In the medium- to long-term period, anything is possible. But in the near term at least, the odds seem to favor the market’s customary fourth-quarter rally. One thing that augurs well for further gains is the fact that so many retail investors seem to be betting against them. The market rarely accommodates such lopsided sentiment.

Fearful Fund Flows

According to data from the Investment Company Institute, the last time domestic equity funds experienced positive net inflows was in April 2011. In the 17 months since then (through Oct. 3), investors have pulled almost $250 billion out of domestic equity funds. And over the five-week period ending Oct. 3, the number of net outflows from domestic equity funds has rivaled the pace of outflows that occurred during the summer of 2011.

That summer, the market was in the midst of a steep correction, so it makes sense that such action would force fearful investors to the sidelines. But over the more recent five-week period, the market actually gained 3.1 percent, while investors exchanged more than $40 billion out of domestic equity funds.

By contrast, bond funds have enjoyed net inflows of more than $335 billion since the beginning of May 2011, and that pace has quickened in recent weeks, with just over $40 billion of inflows over the aforementioned five-week period.

The Halloween Indicator

Despite the bearish outlook of the average investor, the market is about to enter its seasonally favorable period, which is presaged by the so-called Halloween Indicator. This indicator is the converse of “Sell in May and go away,” which is the seasonal pattern with which most investors are likely already familiar.

For whatever reason, the market tends to rise during the period from November through April. And this pattern has the imprimatur of academia, including a recent study by two New Zealand academics that surveyed 108 global markets over all periods for which historical data were available.

The period covering November through April produced returns that were 4.5 percentage points higher on average than the summer months. And over the past 50 years, the gulf in performance between these two periods actually widened to 6.3 percentage points.

But the full results include less developed markets where investors may not be taking advantage of this trend and, therefore, dampening its effect. When the data are narrowed to just the US market, for example, the discrepancy between the summer months and the winter months shrinks to 1.7 percentage points per year for the period from 1791 through mid-2011. But in recent decades, the difference has been substantially greater than it was over the full period. Over the trailing 10-year period through July 2011, for example, the winter months outperformed the summer months by an average of 5.7 percentage points annualized.

Although this trend persists over the long term, there were exceptional periods where the winter months lagged the summer months. In other words, if you hope to use positive seasonality to boost your returns, you should take a long-term perspective toward such a strategy. In the UK market, for instance, the odds of beating a buy and hold by idling in cash during the summer months and going long in the winter months were about 92 percent for each 10-year period. But that winning percentage drops to about 63 percent over a one-year period.

But what is the likelihood that the next six months will still prove to be bullish even after an already robust summer rally? Mark Hulbert, editor of The Hulbert Financial Digest, reviewed the November to April returns for the Dow Jones Industrial Average going back to 1896. He found that the market tends to sustain its momentum following a strong summer, with returns 1.7 percentage points per year higher than the average winter.

Active vs. Passive

Investors also appear to be favoring passive management over active management. While most domestic equity funds are actively managed, there are few exchange-traded funds (ETF) that offer active management. Instead, most ETF portfolios are constructed to mirror a broad or proprietary index. Over the trailing 12-months through the end of August, domestic equity ETFs had net inflows of over $106 billion.

It’s concerning that investors have apparently thrown in the towel on active management. That’s because we may be in an especially propitious environment for individual stock selection. The average correlation between the S&P 500 and its constituent 10 sectors has dropped to 76 percent, according to Nicholas Colas, the director of research at BNY ConvergEx. That may sound like a high correlation, but according to Morningstar, the correlation between these sectors and the S&P has been 84 percent on average over the past four years.

Colas has conducted a number of studies on sector correlation and found that sectors are most highly correlated with the market as it approaches a trough, as investors flee equities en masse. By contrast, a relatively low correlation is the hallmark of a healthy market. And since sectors are no longer performing in lockstep, stock pickers can glean an advantage over indexers by focusing on a company’s fundamentals.

The bottom line: The odds favor the market heading higher during the fourth quarter, and active management could confer an edge over passive management.

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