There are a number of well-known seasonal effects that exist in the stock market; those that are aware of them may stand a better chance to profit from these recurring patterns.
This article takes a deeper dive into examining the stock markets’ seasonally bullish tendency during the final month of the year, commonly known as the December Effect, and how to play with ETFs.
Read more about other seasonal tendencies you can trade with ETFs.
What is Seasonality?
The basis for seasonality investing is that the market tends to behave a certain way during different parts of the year. Even in spite of the efficient market hypothesis, it’s hard to deny the existence of certain seasonal patterns in the market that have been observed for many years.
Consider the following 20-year seasonality study of the S&P 500 Index from Equity Clock. Note that this is a cumulative returns chart, not a monthly returns one:
The two strongest trending seasonal observations are:
- The market typically stages a steep rally in October through the turn of the year
- The summer period, spanning May through September, is generally range-bound
Now let’s examine the former seasonal tendency in greater detail.
Closer Look at December Seasonality
Consider the following chart, which showcases returns in December from 1994 – 2014, day by day, for the major domestic equity benchmarks. Note this is courtesy of Stock Trader’s Almanac, the authority on seasonal trading:
- Equities start strong, but typically see their strength fade by the middle of the month
- All major indexes tend to rally starting mid-month and end in positive territory by the end of the month
- The Russell 2000 has historically posted by far the strongest returns during December
- Historical data suggests the market has a strong bullish tendency during the second-half of December.
Ways to Play
There’s a number of ETFs that investors can choose from when it comes to playing the December Effect. The ones tracking major equity indexes are:
Remember to practice disciplined profit-taking and utilize limit orders when trading ETFs.
Don’t Forget the Fundamentals
Using seasonal patterns as the only factor in your decision-making process prior taking a position is not advisable. Why? Surely you’ve heard this one before: past returns are no guarantee of future performance. Seasonal tendencies are no different. That is to say, just because the market may have historically behaved one way during a certain month does not at all suggest it will continue to behave that way.
Context is everything. What this means is that you have to consider the known seasonal pattern in the context of the current market environment.
Start by examining how the market has performed leading up to the seasonal pattern you wish to trade. For example, if the market was uncharacteristically strong in the summer and nearing a major technical resistance prior to the start of December, it may be wise to consider waiting for a pullback prior to establishing your long position for the month.
Next, you must also consider the biggest fundamental factors at play in addition to past performance. This includes taking note of any emerging risks that haven’t yet been fully “priced into” the market and considering how this might impact the seasonal pattern you are anticipating.
Ultimately, there’s no clear-cut rules for how to trade based on seasonal patterns. You will need to define your own set of criteria, preferably covering fundamental, technical, and sentiment indicators, to use in conjunction with known seasonal tendencies.
The Bottom Line
Planning trades around seasonal tendencies can be a profitable strategy, but it does require more research and more exact timing than some might expect. The trick is executing the trade when seasonality signals align with other signals, including fundamental and technical indicators.
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