Forget a Crash: 16.3% Returns are Possible in October

Fountain pen and glasses on stock chart.
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October is a perilous month to trade stocks

The other dangerous trading months are July, January, September, April, November, May, March, June, December, August, and February.

Mark Twain made this famous observation around 1894. It appears the creator of Tom Sawyer and Huck Finn did not hold stocks in high regard.

Twain made a fortune from his writing. But as an investor he was less successful. Several failed ventures lead to bankruptcy. Perhaps this explains his cynical comments on stocks.

One thing stands out to me. Twain singles out October for a special mention. And he’s not alone. The 10th month of the year has a reputation for trouble.

There is some substance behind the fear of October. This particular month has seen some of the biggest market crashes. The three big ones were in 1929, 1987, and 2008.

So should we be fearful of a crash each October?

Well it’s interesting. Humans have a tendency for selective thinking. We notice events that support our beliefs, and we filter out those that challenge them. Psychologists call this confirmation bias.

Yes, October has seen some big falls. The media reminds us of this each year. This builds upon the notion that October is a risky month. But is it more so than any other month?

Well, there is only one way to find out — let’s have a look at the data. I’m going to start with a table. It shows the average monthly performance for the S&P 500 since 1950.

Source: Moneychimp.com

October isn’t so bad. The average return of 0.7% makes it the seventh most profitable month. In fact, October has been up 62% of the time — that puts it in fifth place.

Now let me break it down a bit further. There is more to an average than a single number. The composition of this figure can be reveling.

October’s worst results were in 1987 and 2008 — the market fell 21.8% and 16.8% respectively. These are far from the typical result. They are outliers — statistical long shots.

We also need to consider the upside. This is an important part of the story.

October’s best returns are 16.3%, 11.1%, and 10.8%. The only other month to have three double-digit gains is January. Most months have no double-digit gains at all.

The other point to make is the size of the returns. October’s 16.3% rise in 1974 is the biggest of any month. The closest figure is 13.2% in January 1987.

An explanation for this strength is that October follows the seasonal weak months. Take the gains of 16.3% and 10.8% for instance. Both followed sharp September sell-offs.

You could call October the rebound month. The next few weeks could be interesting.

It’s funny how we only hear about October’s crashes. Rarely does anyone mention the rallies. And that’s confirmation bias in action — focus on one side, and filter the other.

The message is clear. It makes no sense to sidestep October.

Seasonal swings

You may remember a report I wrote a few months ago. It was about an age-old market adage: Sell in May and go away. The idea is to avoid the period between May and October.

Let me briefly recap…

The saying dates back to a bygone era. It was a time when the aristocracy ruled the market…and their social calendar had a big influence on stocks.

You see, May was the start of the summer social season. There was sport to watch and lawn parties to attend. The market lost its most active players.

With the big money on the sidelines, trading volume would dry up. This had a tendency to increase volatility. The safest bet was to sell and come back at the end of the season.

Have another look at the above table. You will see there is a strong seasonal pattern. November to April is noticeably stronger than May to October.

So forget about sidestepping October. What would happen if we avoided May to October all together? Well let’s do some testing to find out…

The first graph is probably familiar. It uses Quant Trader’s entry and exit strategies.

Take a look…

The start date for the test is 1 November 2005. There is no allowance for the seasonally weak May to October period. The system trades month in, month out.

This strategy performs well. Sure, there are pullbacks along the way. But profits regularly hit new highs — something the All Ordinaries has not done.

Now let’s do another test. This time I’ll make a change. The system will only buy between November and April. It will then exit all positions at the end of April each year.

To be clear, this strategy only operates six months of the year. It sits out the May to October periods.

Okay, are you ready for the results? Let’s have a look…

This is quite amazing. Excluding May to October removes much of the volatility. Profits rise in a smooth series of steps.

Go back to the first chart. Look closely at the big corrections. You’ll see they mostly occur during the seasonally weak months. The years 2007, 2008, and 2011 are a standout.

But there are other things to consider. Some of the May to October periods are strong — namely 2009, 2012, and 2013. Missing these holds profits back.

I have one more graph for you. This is what the two strategies look like side-by-side…

The blue line is the strategy that trades year-round. ‘Sell in May and go away’ is the red line.

It appears selling in May can reduce volatility. But it comes at the expense of higher profits — it’s a trade-off.

Selling in May is an interesting concept. This 10 year snapshot suggests it has merit. But personally, I believe trading when an opportunity arises is the best strategy.

October isn’t such a scary month when you look at the facts. Always be a little skeptical when someone only tells you one side of the story.

The seasonally weak months are now behind us. It won’t surprise me if the 2015 low is in place.

Until next week,

Jason

Editor’s note: Quant Trader’s algorithms have detected a number of new opportunities. They are trending higher, and have the potential to run a long way.

You’ll be familiar with a few of the companies. But many are less well known. These are often the ones with the greatest upside.

The seasonally strong months are now upon us. Take the next step…see what Quant Trader could do for you.

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The Daily Reckoning
The Daily Reckoning offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, The Daily Reckoning delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors. Founded in 1999, The Daily Reckoning is published in 7 countries with a worldwide readership of almost 1 million people.
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