Investor behaviour, santa rallies and other seasonal trends

Back in 1972, Yale Hirsch did a huge favour for investment writers everywhere. In his research for the Stock Trader’s Almanac, he discovered the existence of the Santa Rally - and it’s been a indulgent source of Christmas-inspired stories ever since. Over several decades, the myth that markets generally rise through the second half of December has never gone away - and it’s not the only seasonal trend in the stock market that still lives on.

For those who believe that markets are efficient, the idea of seasonal trends - or anomalies - may seem like a fairytale. How can it be that shares persistently perform better in January, or on Fridays, or on the days before major holidays, or in late December? For that matter, why would shares generally perform comparatively badly in October, or on Mondays, or the days after major holidays? There are various possible reasons, but in general, nobody really knows.

How seasonal anomalies ruin efficient market theory

Take the January Effect. Distinct from the Santa Rally, the January Effect is a trend for stocks to outperform in the first month of the year. Research into this dates back to the 1940s. For example, one study of New York Stock Exchange data between 1904 and 1974 found that the average monthly return in each January in those years was 3.5%. The average return in the other months was 0.5%. That’s an eye-catching difference.

That particular piece of research was mentioned in an article by the behavioural finance theorist, Richard Thaler. Between 1987 and 1990, Thaler wrote a regular column called Anomalies in the Journal of Economic Perspective. They were masterful takedowns of ‘efficient market’ theory. He would set out research that very strongly suggested that human behaviour causes crazy price trends at times. This, he said, was completely at odds with the efficient markets hypothesis, which assumed there was an infinitely elastic supply of arbitrageurs and traders ready to buy or sell whenever prices vary from their intrinsic values.

In fact, in a follow-up article to his assessment of the January Effect, Thaler explored a host of other seasonal anomalies. Among them were weekend and holiday effects, and in each case he showed that share prices do see seasonal trends. He pointed to research finding that stocks go up more on Fridays than they do on Monday, and that pre-holiday periods are very strong for share prices.

Why seasonal trends exist at all

It’s unclear why these trends exist. For some, like the Santa Rally, the causes are often blamed on tax-driven trading. But that doesn’t fit well in regions like the UK and Australia. Both these countries see evidence of Santa Rallies, yet their tax years don’t end in December.

An alternative cause is that fund managers ‘window dress’ their portfolios with the market’s hottest stocks (whilst selling down their embarrassing positions). Some even suggest that rising prices reflect an element of positioning ahead of the anticipated January Effect.

More broadly, research into seasonal anomalies points to much more straightforward behavioural reasons. They include investors being happier on Fridays than they are on Mondays, and more bullish ahead of holiday periods and the start of the year.

To take this a final step further, some of the latest research in this field actually suggests that every stock in the market has something called a “mood beta”. In other words, some stocks are more sensitive than others to seasonal periods. Unlike a regular “beta”, which is a measure of a stock’s sensitivity to the movement of the market, mood beta is a measure of a stock’s sensitivity to investor mood.

The research by a team led by American economist David Hirshleifer showed that stocks that do particularly well during ‘good mood periods’ - like January, Friday and pre-holiday - tend to do consistently well at these times. But equally, this same set of stocks underperforms during downbeat mood periods, and tend to consistently underperform during these periods. These findings support the increasing evidence over the past 20 years that investor emotion and behaviour have a big, often unseen influence on share prices.

You can’t trade seasonal effects - but there are lessons

What can we take from this? Thaler was clear in his writing that despite the presence of seasonal anomalies, they were next to impossible to exploit. That was particularly the case for private investors faced with regular trading costs. The bid-ask spreads and dealing fees, particularly in small-caps, meant that there were never going to be fabulous opportunities. But he rightly insisted: “Even if no-one could make money as a result of the seasonal anomalies we should be interested in learning why they occur.”

Decades of research, right up to the modern day, points to an intriguing relationship between price trends and human behaviour. While it might not be easy to exploit these anomalies, just being conscious of seasonal trends and how they can be driven by human emotion can be an advantage.

We’ll keep a close watch for a Santa Rally ! But in the meantime, have a great Christmas from everyone here at Stockopedia - and thanks for all your support !