This is one of the worst starts to the fourth quarter in decades. But what that means for the rest of the year may surprise you …
Yesterday’s start to Q4 was a rough one for the markets. And today is becoming downright ugly.
As I write Wednesday early afternoon, the Dow is sinking 550 points. This is largely due to yesterday’s bad report on the U.S. manufacturing sector, which has rattled markets and stoked recession fears.
The report, from the Institute for Supply Management, indicated that its manufacturing index fell to 47.8% last month. That’s down from 49.1%. Any reading below 50 indicates a contraction in the manufacturing sector. Tuesday’s reading marked the lowest level since June 2009.
Another bad sign is that just three of the 18 U.S. manufacturing industries tracked by ISM reported growth. That’s down from nine in the prior month.
Then, there’s the negative news that corporate stock buybacks are slowing. Many analysts believe that corporate buybacks — which hit a record of over $1 trillion in 2018 — have been pushing the stock market higher. But we’ve learned that in Q2, the S&P share buybacks number came in at just $160 million. That’s about 20% less than Q1. It’s also about 20% less than the reading for Q2 of last year.
If we look at the markets from a technical perspective, the Dow has now broken below both its 50-day and 100-day moving averages. These are two technical levels which traders watch closely. Falling below them is a bearish signal.
***Now, before we run for the hills, there’s a silver lining …
According to the investment research shop, Bespoke, some of the worst starts to October have been followed by huge gains for the remainder of the month and year.
Specifically, there have been 14 times when the S&P fell by more than 1% on the first day of Q4 (which is what happened yesterday). So, what has this meant for the rest of October when this has happened? Turns out, the S&P has gained an average of 3.75%.
Even better, for the rest of the year, the S&P has been up 12 out of 13 times, for an average gain of 7.22%.
On top of that, Q4 is historically the best-performing quarter of the year, with many analysts pointing toward the fabled “Santa Claus Rally.”
We actually referenced some 4th quarter statistics in a Digest last week, pointing toward this historical outperformance. But that got me thinking — how likely is it to happen again? And while the gains might be bigger, do they come with greater volatility as well? Basically, what’s the real story with Q4?
With these questions in mind, I turned to our resident quant and editor of Strategic Trader, John Jagerson. Being a “quant” simply means John uses real, historical market data to identify patterns and trends. Then he uses that information to help make well-informed predictions as to what might happen in the markets going forward.
John graciously dug into the numbers for us and wrote up the results. So, at this point, I’m going to turn it over to John. I’ll circle back with you after his piece is finished.
***Q4 returns are the best — but also the riskiest
Investors are obsessed with any information that may give them an edge. The goal of fundamental and technical analysis is to detect when a stock might be currently undervalued or likely to otherwise rise in the future. One strategy investors have tried in a variety of ways to find an edge is calendar based — or seasonality investing.
If you have ever heard the expression “sell in May and go away,” or are familiar with the “Santa Claus rally” then you already know something about calendar investing. A calendar-based investing strategy attempts to profit by timing trades based on dates on the calendar rather than fundamental or technical information. To be honest, most of the data available on calendar or seasonal cycles aren’t very good, but there are a few ideas that are worth further investigation.
There is an interesting relationship with returns in Q4 of the year versus the other three quarters. Since 1985 the average return on the S&P 500 during Q4 is 4.02% compared to 2.79%, 2.68%, and 0.36% in Q1, Q2, and Q3 respectively.
However, this is only half the story; investing in Q4 can be risky. If you told me I could make 4% but I had to take a lot of risk, I would be less interested than in an alternative opportunity where I could make 2-3% with very little risk. Considering the potential returns of an opportunity should always be balanced against the risk that is expected.
When I calculated the average return of each quarter, I also evaluated the risk of those returns by looking at the standard deviation of the data. For those of you who don’t want to take a statistics course, a standard deviation tells me how widely the data was spread. For example, it’s great to make 10% but what if you also regularly lose 12%? The spread between the typical winners (10%) and the average losers (-12%) is very wide so its standard deviation tells me that trading strategy is very risky.
In the following chart, you can see that Q4 returns are the best, but the risk in the Q4 is also the highest. However, if we compare the average risk with the average return, Q4 is actually still the best performing quarter overall.
As you can probably imagine, Q3 is the worst on a risk adjusted basis because it is the second riskiest quarter and the least profitable since 1985. Q2 is nearly as good as Q4 even though its returns are lower because its risk is also lower. Q1 is a laggard but still not as bad as Q3.
What could cause this phenomenon?
Explanations for this difference in risk and returns vary and although this is difficult to prove, I suggest that Q4 is the best because of the holiday culture in the West. The Q4 shopping season is a big deal; holiday and end-of-year bonuses are announced in Q4; and professional investors rebalance their portfolios more extensively in Q4 than in other periods.
I think this is the reason the “Santa Claus rally” exists. The Santa Claus rally is the tendency for stocks to rise the last week of the year and the first few days of the new year. Some differences between Western and Asian cultures could explain why this same seasonal phenomenon does not exist in Asian market indexes.
What can investors do with this information?
In theory, this means Q4 is the best bet and investors should plan to allocate their portfolio to the market in the last three months of the year. That is true if we look at the average performance of the market, however, the actual performance of an individual quarter is going to vary a lot from the average. For example, Q4 of 2018 ended with a massive -14% loss.
My advice is to go with the data and make sure you don’t skip Q4, but keep your expectations reasonable. The average performance in Q4 is very good, but some years, it will still be rough. Q4 offers the best risk-adjusted return, but it also has the highest level of volatility of each of the four quarters as well. Pay attention to diversification, or other portfolio protection strategies, to avoid getting caught in another 2018-style debacle when the S&P 500 dropped into a bear market.
***How will this Q4 end up?
Jeff here again.
One note on the ISM report that sparked the selloff we’re currently enduring …
You have to remember that the manufacturing sector represents only about 10% of the U.S. economy. Services represents the other 90% or so. With this in mind, yes, we need to pay attention to the ISM report, but do so with objectivity.
History suggests Q4 gains are coming, even with this pullback — actually, even more so because of this pullback.
We’ll continue to keep you up to speed.
Have a good evening,
Jeff Remsburg
