I want to begin by saying that nothing makes me happier than waking up to a pleasantly brisk cool morning following the dreadful summer heat. Although I have lived in Texas my entire life, I have yet to become accustomed to the blistering summer days, and probably never will. So, it goes without saying that Thursday’s delightful cold front brought many exciting reminders of what lies ahead: vest season, pumpkin spice lattes, my wedding anniversary, my birthday, the end of year holidays, and so forth. Needless to say, this upcoming season is my favorite!
While we are all subject to seasonal weather patterns, we too are subject to seasonal occurrences within statistical data, such as the financial markets. Over coffee this morning, I discuss seasonality within the financial markets, which will provide further context on why we’ve taken a constructively cautious approach, per our conversation last week. So, grab your cup of coffee, or pumpkin spice latte, and enjoy!
Last week over coffee we highlighted how we’ve been constructively cautious of the froth manifesting within the financial markets. A number of our sentiment indicators, namely the Put/Call Ratio shown in last weeks note, signified that many investors were exhibiting signs of complacency. In truth, it didn’t take much effort to realize the asset mania that was unfolding in a select number of beloved Wall Street stocks. To illustrate this mania, the chart below shows the chart for Tesla overlaid to the chart of Bitcoin during its meteoric rise in 2017. Although the past doesn’t signify what will happen in the future, there is a striking resemblance that stresses caution.
Now, to be clear, asset mania and/or euphoric complacency is not a standalone catalyst as markets behave irrationally longer than an investor can stay solvent. What led us to take a neutral/cautionary stance was deduced from our investment strategy process. As we highlighted a few weeks ago, we believed we hit a point where valuation extremes, overcrowding sentiment, seasonality, and political uncertainty all pose a negative catalyst for the financial markets. As mentioned earlier, financial markets, just like the weather, experience periods of seasonality. Seasonality, as defined by Investopedia, is a characteristic of a time series in which the data experiences regular and predictable changes that recur every calendar year. Any predictable fluctuation or pattern that recurs or repeats over a one-year period is said to be seasonal. With this understanding, we ran an empirical study to see if seasonality exists within the stock market. We ran the return sequence, on a weekly basis, for each calendar year from 1950 to 2019 to ensure we have an adequate sample set. What we found, see chart below, is that the stock market, historically, experiences negative weekly returns from September to October.
To further this, we reran the analysis to see if seasonality persisted during election years. What we found is that it not only exists but demonstrates a higher level of volatility until the election.
While seasonality is a normal occurrence, based on the empirical evidence, our caution stems from an amalgamation of market risks; seasonality, political uncertainty, put/call ratios, and overcrowded investment. With that being said, we believe we are in the early innings of a renewed business cycle which should usher relative outperformance of economic beneficiaries in the coming months. We believe the recent market pullback is analogous to seasonal patterns and current market structure rather than representing something sinister brewing underneath the surface, based on the outperformance of economic beneficiaries amidst this recent pullback.
Have a wonderful weekend and call or email with questions!
Andrew H. Smith
Chief Investment Strategist