By Tim Courtney, Chief Investment Officer
Many spend their lives searching for the holy grail of investing – a strategy that captures positive returns but avoids risks and downside. And with almost a century of market data to use for research and study, there are several patterns and rules that are said to help in this quest. One such pattern is the "September Effect" – a finding that markets tend to have lower performance in September and October.1 The only month to have a negative average return since 1926 is September, although it’s because of several large negative Septembers during the Great Depression. As it turns out, we’re about to have another negative September in 2023.
Similar observations have led to other calendar-based rules such as "Sell in May and go away," which suggests investors stay out of the market during the summer and fall months. Returns have been lower but positive in these months, and avoiding them would have led to a large amount of lost returns and compounding. You might also be familiar with the Santa Claus rally in December and the notion that January's market performance can predict the rest of the year.2
Humans are excellent at spotting patterns, which is a beneficial ability and has helped us better understand our world. But sometimes this ability can lead us astray. Meaningless or random patterns will occur naturally in large sets of data. As popularized in the movie “A Beautiful Mind”, the brilliant mathematician John Nash discovered patterns in print media that were nothing more than coincidences. Others have found patterns in large books such as the Bible or Moby Dick. With nearly a century of stock data and supercomputers looking for patterns, we will find some. The question is: are these patterns purposeful or caused, or are they random?
This brings up the study we’ve mentioned before that pitted humans against mice. Mouse and man were separately placed in front of two lightbulbs with buttons underneath. The goal was to have the subject press the button under the light they thought would next flash. If they guessed correctly the subject would get a reward. There was a pattern to how the lights flashed in that one flashed 80% of the time and the other 20%. However, the order was random. The humans could recognize that one lit up about four times as often as the other. They pressed the button under the light they believed was “due” to flash. But because the order was random they often guessed incorrectly and had a success rate of about 68%. The mice quickly discovered that one light paid a reward most of the time, and they only pressed the button under that light. They guessed correctly about 80% of the time.4
The market has a comparable pattern and random order. Market history shows that markets are positive in roughly two-thirds of all months, quarters and years.3 However, the performance of the previous period doesn't reliably indicate what will happen next. Regardless of whether the prior month, quarter or year was positive or negative, the next period is positive about two-thirds of the time.
This is not to say that all patterns in markets are meaningless. However, it is to say that performance patterns have been tied to some level of risk being present. We believe our best approach is to acknowledge and manage the risk necessary to capture returns.
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