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Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors.
Before trading, please ensure that you fully understand the risks involved
Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors. Before trading, please ensure that you fully understand the risks involved

Tuesday, October 27, 2020

Will elections spook the market this Halloween?

by Century Financial in Investment Insights

Will elections spook the market this Halloween?
Will elections spook the market this Halloween?

*This performance is only observed with historical backtests and not traded by the company.

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The product and investment ideas do not consider the risk profile and financial position of the recipient and may not be suitable for everyone. Trading in financial markets and use of margin involves a significant risk of loss, which can exceed deposits. Please read the complete disclaimer carefully.

Stocks investors might be in for a treat according to a theory called the Halloween Effect. The theory focuses on the idea that the stock market tends to rally more during the six months after Halloween than it does in the six months before Halloween.

Research shows that stock markets exhibit significant seasonality with the performance being consistently better in the winter months between November – April.

Since 1950, US SPX 500 Index has gained an average of 6.8%, from November through April versus 1.65% from May through October.

SPX 500 Charts: 1950-2020

$10,000 invested only during the period from Nov-April every year from 1950, and out the other 6 months, would have resulted in $771,506 in 2020.

$10,000 invested only during the period from May through Oct every year and out the other 6 months, would have resulted in $24,159 in 2020.

Obviously, it goes without saying that if one would have stayed invested throughout the year starting from January 1, 1950; $ 10,000 would have grown to $2,038,415 in October 2020.

The old adage “sell in May and go away” has been around for decades. However, many have ridiculed the theory over the years and attempted to disprove it. But two new pieces of academic research have confirmed the Halloween effect, is a highly dependable trading strategy to hack.

In the biggest study of its kind, Ben Jacobsen, professor of finance at TIAS Business School, and Cherry Zhang from Nottingham University Business School analyzed the monthly returns from all 114 stock markets in the world, going back over 320 years. The research observed that on average stock markets rose 5.1%, from November to April, compared with just 1.1%, between May and October. The higher mean returns were evident in 89 of the 114 countries with the difference statistically significant in 42 of those countries, compared to only one country, Mauritius, that had significantly higher returns for May-October.

If we were to go by the books, Halloween effect should not work. According to the efficient market hypothesis, pricing of assets reflects all known information. So anomalies like the Halloween effect, which are both known and highly predictable, should quickly fade away. However, according to the latest research, a separate study by four academics, the Halloween strategy is real and continues to provide opportunities to develop a trading strategy that can beat the market.

However, investors need to be prudent as this year is not like any other year, with the economy facing the ravages of COVID-19 and suffering serious damage, the market may suffer losses in the future. Besides, next week are the US presidential elections and one of the biggest fears amongst investors is the possibility of a messy election outcome as US President Donald Trump has refused to commit to a peaceful transfer of power if he loses November's election. This indeed sounds worrying since Biden lead in battleground states has dropped from 5% on October to 3.8% on October 26th.

The shrinking gap suggests the odds of a contested election are increasing, as President Donald Trump has already indicated he might avoid conceding the race if margins are small in key states. In this case, the most obvious precedent can be the 2000 election contest between George W. Bush and Al Gore where tech heavy Nasdaq and SPX 500 fell by 24% and 8% respectively in the month of November. As can be seen in the table, in the year 2000, SPX 500 fell by 13% between Nov-April.

Also, another fact to note is that while the Halloween Anomaly does hold true even in the election years, the probability as well as the gap between the two periods is much lower. As a result, investors are advised to be highly prudent and should play their trick wisely to enjoy the privilege of a treat.

Having known about the Halloween effect, one question popping up in everyone’s mind, would be what contributes to this seasonal effect. Well for all the academic study that has been carried out into the Halloween effect, none has ever been able to provide a satisfactorily explanation with regards to why it happens.

Halloween Anomaly during Election Years (1950-2020) for US SPX 500
Election years Returns from Nov-April Returns from May-Oct
1952 0.4% 6%
1956 0.4% -5%
1960 22% -1%
1964 5% 6%
1968 0.3% 6%
1972 -4% 5%
1976 -4% 2%
1980 4% 21%
1984 8% 4%
1988 11% 7%
1992 5% 1%
1996 14% 8%
2000 -13% -2%
2004 2% 2%
2008 -10% -30%
2012 13% 1%
2016 12% 3%
2020 ? 15%
Average Return 4.0% 2.6%

Mentioned below are some previously explained theories behind what drives stocks higher November through April:

  • First, is the so-called mutual fund "window dressing," in which portfolio managers basically sell the loss-making stocks before 3rd Quarter statements are sent to shareholders.
  • Year-end bonuses also tend to go right into the stock market, which increases cash inflows& liquidity and drives the market higher in the fourth quarter and first quarter.
  • Investors tend to be more optimistic about the markets after an ominous October is out of their minds. Historically, October has a bigger percentage of correction and bear-market bottoms than any other month. It’s experienced two Black Mondays, one in 1929 and the other in 1987. Black Tuesday and Black Thursday in past Octobers have also rattled the investors. And then 2008 financial crisis in which the S&P 500 lost nearly 17% in the month of October.
  • New money is seen flowing into the stock market at the beginning of each year as pension funds add to their holdings at that time. Also, before 15 April tax deadline, investors inject more capital into the markets to fund their individual retirement which contributes to a rally in April.

However, these past theories, have all been debunked and may be its just that the Halloween effect that retains an air of mystery.

*Past performance is not indicative of and does not guarantee future results. Trading in markets may involve loss of capital.

Risks & Assumptions

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The strategy might suffer from look-ahead bias which occurs due to the use of information or data in a study or simulation that would not have been known or available during the period being analyzed. This can lead to inaccurate results in the study or simulation.
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Future price movements may not be exactly the same as the historical price movements and this could lead to variation in performance.
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Testing can sometimes lead to over-optimization. This is a condition where performance results are tuned so high to the past they are no longer as accurate in the future.
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The model assumes no slippages in trading. Slippage refers to the difference between the expected price of a trade and the price at which the trade is actually executed.
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Drawdowns in actual trading can be higher than the tested system and losses could be significant in the event of leverage.
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Unforeseen events can lead to variation in performance from the tested trading strategy.
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The tested result has been computed with price feeds available from Bloomberg.
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The testing environment has not considered transaction or any other costs.
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Trading indicators used for the purpose of testing has been provided by Bloomberg.
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The strategy might suffer from data mining fallacy, selection bias and backfill bias.

Data Source: Bloomberg

Arun Leslie John
Chief Market Analyst

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