The Santa Claus rally and other market myths
We’re approaching the time of good will to all, and the much-vaunted Santa Claus rally. But how much of its reputation is based on fact?
And how much is more attributable to the fact that more of the population have now heard of it, whereas they may never have done even 20 years ago; and how many now have easy access to markets while they are bored during the Christmas-New Year break. They may still have been bored 20 years ago, but now can trade discretely from a smartphone while the family watch Home Alone and eat mince pies.
A December rise is also explained by many as the result of fund managers rebalancing portfolios for next year, or City bonus payments being staked with confidence and absolutely no inside knowledge.
In separating fact from fiction, a review of data is required. Much is available on the web, with convincing conclusions that over time December is the best month of the year for stockmarket returns, and the last two weeks of the year are often best too.
Reviews in The Stockmarket Almanac and What Investment conclude that December is best over multiple years.
Where to start?
But the 1970s and 1980s were different from now. When it became different is hard to say, but faster internet access was key. That came with ISDN in the late nineties, followed by ADSL broadband a few years later.
So the year 2000, the new millennium, seems a reasonable place to start.
Then is the question of what data set to use, the FTSE 100 or broader All-Share index.
So here are the results from both. Remember that they are presented with no agenda and no wish to burst bubbles or dampen optimism – we need as much of that as we can get.
The data was sourced from Investing.com, now one of the few easy to access free historical index data download providers – Google and Yahoo having either stopped offering index data or been unreliable. The LSE website seems to be complex for the sake of complexity, making it hard to find, let alone download.
One of the other key factors in determining the published results was that the figures were averages, and is perpetuated here for consistency.
The data shows that on average December is a great month to be invested in the FTSE 100, but not the best. The monthly breakdown in Table 1 shows that the average is dragged down by poor performance in 2002 and 2014-15.
This is echoed in the FTSE All-Share data.
Likewise, the chart in Figure 1 shows how April and July have more positive than negative months, in both the FTSE 100 and All-Share data.
October and February are also good performers.
The Table 1 data set analysis also confirms another commonly held adage, “sell in May and go away, buy again St. Legers day”.
Sell in May…
The data reveals that in the years featured – on average – it would indeed have been wise not to be long on equities.
July is the only month between May and September that bucked the trend. A close look at Figure 1 reveals it to be slightly more hit than miss, and more binary. If it went up, it went up strongly, and vice-versa.
The monthly rises and falls for July aligned again perfectly, confirming that it mattered not if your portfolio was broader across the All-Share or FTSE 100 blue chip oriented.
And so in answer to the question “should I buy the Santa Claus Rally”, the answer seems to be that recent history backs you. But you must bail out by January, when the odds turn distinctly against you. But you’ve still got more chance of winning with UK shares in January than by buying a lottery ticket.
Taking the monthly averages data from Table 1 into chart form in Figure 2 below, you can see clear patterns, and may be able to interpret best times to enter or exit the market.
But such a strategy would apply only to broad brush portfolios, such as index tracker funds, ITs or ETFs; the data is meaningless at an individual company level.
Finally, before making your investment decisions, remember that past performance is not a guide to the future; and these other sensible observations:-
Mark Twain “Facts are stubborn things, statistics are pliable”
Benjamin Disraeli “There are three types of lies – lies, damn lies and statistics”.
Asset alignment narrows your choices
Recent history has created situations that are not consistent with what we have come to expect. For example, low inflation and low interest, extended periods of very low interest, and asset alignment.
Broadly this means that – unlike in the past – assets which previously changed in value in inverse proportion to each other no longer do so.
Whatever the equity markets do, we used to anticipate that there may be an alternative, a haven to switch to so as to maintain an upward momentum.
But some of the old options have vanished. For example, share prices and bond yields tended to rise and fall together. Gold would be expected to fall if interest rates rise, and if the US dollar is strong.
But other factors are now influencing how prices move.
One key factor is uncertainty, especially over the US presidential election next month. Given the recent revelations about Trump, Clinton should have it in the bag. But it seems she is not much liked either. And after the shock result of the UK Brexit vote everyone has been left with the nagging doubt that anything could, and might just happen.
Shares and bond yields align
Throughout the summer of 2016 US share prices and bond yields moved in the same direction on just 11 of 30 trading days.
This alignment does happen from time to time, but this year it has been longer. The last time was when the Federal Reserve signalled the end of their stimulus programme in 2013, an event now known as the “taper tantrum”.
Part of the problem is thought to be an expectation that, even if interest rates rise, they will remain extremely low for an extended period, some say maybe even forever. This leaves economies exposed to reaction shocks when faced with what might have once been regarded as a small change: in the UK even a change of 25 basis points – one quarter of one per cent – represents a 100 per cent rise; or fall. Interest rates haven’t “doubled” since 1988.
Earlier in 2016 the Japanese 40 year bond dropped 20 per cent over worries about future fiscal stimulus, and the bank’s ability to deliver. This was previously considered a “safe” investment.
And a similar situation has occurred with shares and the oil price. Ben Bernanke, former Chairman of the Federal Reserve, suggested in his blog on Brookings.edu that equities are volatile because oil is volatile. He concludes that equities are more volatile because global demand for oil is slowing, and that suggests that global growth is falling, and in turn earnings will fall.
Bernanke proposed some other explanations. Firstly, that the positive correlation between oil and share prices (as opposed to negative, as we’d expect) could be due to the tendency for oil prices and shares to react to common or similar factors in the same way. For example, changes in demand, overall certainty and risk aversion.
Or that as higher oil supply affects prices, the profitability and creditworthiness of oil producing companies and even countries could be reduced.
Madness of the crowd
But it could be just collective panic. When investors are buying they buy everything, and vice-versa. Many transactions influencing the price of commodities are now share based, through Exchange Traded Funds. So now it’s just as easy to dump gold and oil as to sell Tesco and Barclays.
And when looking for a haven when days are dark, if investors realise that holding gilts won’t cushion any fall in equity prices, and traditional balances like gold are moving in the same direction, where do they go for a safer alternative?
Two possibilities come to mind, one much easier to trade than the other. However neither are silver bullets. They have pros and cons like any other investment, and in some cases these may be a short-term trade solution to a falling equity market rather than a real asset allocation offset.
Firstly, inverse ETFs. These are obviously synthetic rather than physical, and constructed to increase in value as the underlying asset declines. Yet they only work precisely if the market declines consistently. For example, if the FTSE 100 were to decline 2 per cent per day, after 5 days it would be at 9.61 per cent lower. An inverse ETF would have increased by 2 per cent per day, and be 10.41 per cent higher.
But if the market fell 5 per cent on one day, and then up and down by 5 per cent per day over 5 days, the index would be down 5.47 per cent, yet your inverse ETF would only be up 4.48 per cent.
And in a market that drops only to steadily recover, as in the example in Table 1 below, an index starting at 10,000 may recover but the leveraged ETFs will lag.
|Index Value||Daily Change %||Inverse ETF||2x Inverse ETF|
While the index returns to its previous value, the inverse ETF is slightly lower, and worse still is the result if you’d opted for a 2x leveraged ETF.
But overall we have to accept that insurance, which is ultimately what this is, has a cost.
Another alternative, perhaps not as easy for many to trade, but still easier than buying and selling shares was up to the new millennium, are put options on an ETF that tracks or mimmicks a major index. These should preferably be LEAP (long-term) options that have a reasonable time before expiry.
These need to have at least 6 months to run, and if the downturn you are guarding against looks like being longer, then make it a year or more.
The downside to these is that the rate of change in their value changes with the volatility, so if the index goes down one point in regular trading, the puts increase by less than the equivalent one point if the market collapsed by 100 points in an hour.
And because put options have intrinsic and time value, the longer you hold them the more the time element of their value deteriorates.
Time value decreases faster as expiry approaches, and so it makes sense to roll put options over – sell them and buy new ones – while there is a couple of months to spare.
The traditional relationship or correlation between certain asset classes is changing, aligning previously diverse assets. You can no longer expect to switch from one to another and expect an ever increasing pot. But you can watch the performance and trends of different asset classes more easily than ever on the internet, and there are more choices available for longer- and shorter-term strategies.
But for many, a traditional stop loss may still effectively provide the most reassuring change of asset class.
Where does Brexit point your next opportunity?
Who put money on markets reaching year to date highs, and in some cases, all-time highs on June 24th?
This is a another reminder of the opportunities created by the “flash crash” reaction to news events. When uncertainty is introduced selling, if not panicked selling, will likely follow.
Only when the dust settles can the real impact be known. But fairly quickly assessment can be made as to how appropriate the level of reaction was.
The BoE Monetary Policy Committee have reduced interest rates by 0.25 – or halved them – and added £60bn to the quantitative easing programme, with the objective of forcing down yields so that other – riskier – assets would be sought for their better yield.
This is just an extension of what we had already, where gilts yield little and blue chip bond proxies come to the fore.
Long term objectives don’t change, and short term opportunists just need to avoid the punchbags, those still on the ropes, like Banks and Financials, Life Assurance and Real Estate.
The big winners in 2016 so far have been Industrial Metals, Mining and Technology.
But investing in many other sectors would show gains for 2016, especially after June 24th.
The Brexit vote showed though that such curve balls produce reactions well beyond the boundaries of the host economy. Global equity and currency markets fell in unison. The 8 per cent drop in sterling and UK, European and US stockmarkets translated into similar percentage gains for gold, the Japanese yen, Euro and US dollar.
The Brexit implications still reverberate. Ministers assigned to making the exit deal apparently don’t like or agree with each other, and not much progress has been revealed. This suggests that when something does eventually happen, it may cause further furore.
What we know
The fall in sterling value has known effects; it will cost importers more to buy in materials. Exporters will enjoy the benefits of increased sales as overseas business buys at bargain prices. Share prices of companies will likely reflect their fortune.
And the larger multinationals listed on the FTSE 100 are expected to fare better than smaller companies further down the chain, as their exposure is limited in the UK, or may even benefit from currency movement.
This is reflected in the performance of the Smallcap (SMX) and FTSE 250 (MCX) indices, shown in Figure 1 in comparison to the FTSE 100 (UKX).
At the start of the year these indices all moved downwards broadly together. By mid-June they were all together following the pre-Brexit vote confidence blip and obviously not expecting the final result.
While all markets have improved since, and are all showing gains for the year overall, it’s the smaller companies that are underperforming comparatively.
In the UK the FTSE 250 is worst, and the Nasdaq Composite in the US. These indices reflect large numbers of mid size companies, the ones where most uncertainty remains. In the US though many smaller companies are insulated from what happens outside.
Every silver lining….
The Brexit vote has unwittingly causes another dilemma; markets reaching highs tend to fall back. So how far will they fall, or have they already done that?
It leaves some hesitancy about blue chips. With gilt yields still falling blue chips to consider are the bond proxies, defensives like Unilever and Reckitt-Benckiser that will carry on regardless.
In the US the favourites are Walmart, Pepsi-co. Proctor and Gamble and Kimberly-Clark.
The defensive benefits and higher quality bonds offer both income and safe returns.
Investors with cash might want to consider smaller companies. While they are generally considered slightly more risky than large ones, there is a view that the risk reduces over about 5 years. So longer term investment in smaller companies can offer greater returns for a similar risk. Spreading risk globally, and considering emerging markets also makes sense in spreading that additional risk.
There is also the consideration of non-equity based diversification through alternatives such as metals – currently in a strong bull run – and fine wines, where all the main indices have turned up in 2016.
Chris Gilchrist identified several funds that offer exposure to global small companies in The IRS Report last month.
They include Aberdeen’s Asian Smaller Companies IT, Ballie Gifford Shin Nippon IT and OEICs from Invesco Perpetual, the Global Smaller Companies, and Threadneedle’s European Smaller Companies.
All offer exposure to companies where business is less likely to be affected by the global events, but where share price movements will provide bargains from time to time.
But there are indicators recently revealed that bets against sterling – shorting the pound – are gradually being undone, and at volumes larger than just a bit of profit taking.
This follows Markit Economics revealing better than expected PMI figures from France and Germany, suggesting that the handcart awaiting departure may well remain parked for a while.
Things may not be as bad as the reaction to the Brexit vote suggested. But they hardly could be. But if that event was the sunshine on small company hay, why not reap some? There are likely more small company winners out there awaiting their day, and you can make it your day too.