Market Timing via Monthly and Holiday Patterns

A Free Lunch in the Stock Market

A Market Brief
by

Steven Kim

MintKit Investing
www.mintkit.com

Disclaimer This brief is provided as a resource for information and education. The contents reflect personal views and should not be construed as recommendations to any investor in particular. Each investor has to conduct due diligence and design an agenda tailored to individual circumstances.

2012 MintKit.com

Summary

The stock market displays a variety of patterns that can serve as the crux of a timing strategy. A showcase lies in the oft-seen surge of the market around the turn of the month as well as the run-up to a holiday. As with all things, the timing strategy does have its shortcomings. An example involves the need to dart in and out of the market more than a dozen times a year in order to take full advantage of the patterns. Another drawback stems from the higher rate of income tax on short-term profits as opposed to long-run gains in the stock market. The precise impact will of course depend on the specific circumstances such as the traders country of residence. Despite the hassles, though, trading with the calendar can produce a higher payoff at less risk than the humdrum policy of buying stocks and holding them indefinitely. For this reason, a timing strategy based on monthly cycles and market holidays represents a free lunch on Wall Street. * * * Keywords: Cycles, Market, Timing, Monthly, Patterns, Stock, Bond, Market, Performance, Analysis, Tax, Investing, Risk * * *

* * * According to the simplistic models of financial theory, the stock market moves in a random fashion devoid of any type of order or structure. In reality, though, the bourse exhibits a variety of patterns. The recurrent themes include a bunch of cycles that can be used as the groundwork for a timing strategy (Kim, 2010; Wikipedia, 2010). As an example, a long-lived motif lies in the tendency of the bourse to surge around the turn of the month. Another frequent outcrop is an upswell of the market just before a holiday. The hardy templates of this sort may be used by the deft investor to carve out higher returns. In particular, the timing scheme can beat the bland ploy of buying stocks at the outset and holding them without letup. Another draw of the timing approach lies in the cutdown of risk compared to the default policy of buy-and-hold. More precisely, the volatility of the nimble portfolio is markedly lower than the thrashing entailed by the crusty scheme of holding onto a position through thick and thin. Thanks to these traits, the average return adjusted for risk outshines the conventional ploy of buy-and-forget. Better returns at lower risk: heres a stark sample of a free lunch on Wall Street. In the sections to come, we begin with a survey of the causal factors behind a couple of durable patterns in the stock market. The perennial motifs can be used to advantage not only by the short-term trader but the long-range investor as well.

Driving Forces
The stock market has a habit of surging around the turn of the month. The bounce in price is a telltale of a net influx of funds into the bourse. No doubt one reason for the monthly hop is the habit of the general public for plowing part of their income into the market around the end of the month. After paying off their bills, the mass of investors can decide how much of their savings to funnel into the capital markets. A second, and related, driver lies in the allotment of funds by organizations into pension funds. An example involves the matching contributions from employers to the retirement accounts managed personally by the workers. The inflow of cash is a godsend for the beneficiaries over the long range as well as a tonic for the bourse in the short run. A third factor stems from the habit of many a professional trader to liquidate their short positions prior to taking off for a holiday. On the whole, hard-core professionals are more likely than casual investors to take up the dicey habit of shorting a stock; that is, borrowing shares from their brokers and selling them to other traders. To close out their positions, the punters are obliged to buy up the corresponding shares in order to repay the loan of stock. The transaction gives rise to a transient surge in demand for the equities. For instance, a stock that has been borrowed and sold short a week earlier has to be replaced by procuring the same number of shares on the open market. In this way, the closure of the position gives a boost to the equity. Another reason for the buoyancy of the market just before a holiday springs from the jaunty atmosphere in the population at large. Amid the general air of good cheer and high spirits, investors of all breeds are more likely than usual to throw in an extra glob of spare cash into the market in spite the hazards in store.

In these ways, a variety of motive forces come into play around the turn of the month or just before a holiday. The outcome is an upswell of demand for stocks, which shows up as a boost for the market at large.

Icon of Market Timing

In the area of market timing, a vanguard is found in an analyst named Norman Fosback. In 1971, the pioneer co-founded a research group named The Institute for Econometric Research. After studying the stock market for several years, the investigator came up with a trading scheme which came to be known as the Seasonality Timing System (Fosback, 2010). The centerpiece of the program was a sally into the stock market toward the end of each month, followed by an exit shortly after the onset of the following month. A similar approach was used in engaging the bourse over the span of a few days prior to a holiday during which the market would be closed for business.

Recipe for the Timing Strategy Since it was first introduced, the Timing System underwent a number of minor revisions. Even so, the basic ideas have remained the same. The thrust of the trading strategy has been packaged into a handy set of decision rules by a renowned prober of market strategies. According to Mark Hulbert, founder of the Hulbert Financial Digest, the key features of the Timing System are as follows (Hulbert, 2003). 1. To exploit the positive seasonality around the turn of the month: Buy at the close of the third-to-last trading day of each month, and sell at the close of the fifth trading session of the following month. 2. To tap into the pre-holiday upturn: Buy at the close of the third-to-last trading day prior to a holiday for the stock exchange, and sell at the close of the last trading day before the holiday.

3. Exceptions to the foregoing rules: If the holiday falls on a Thursday, sell at the close on Friday rather than Wednesday. Also, if the last day before a holiday is the first trading day of the week, dont sell until the day after the holiday. Finally, never sell on the first trading day after options expire; instead wait an extra day. By adhering to the Timing System, the portfolio is exposed to the stock market less than half the time. During the remainder of the calendar, the money can be stashed away safely in interest-bearing vehicles such as money-market funds.

Sturdy Performance Looking at the big picture, the techniques for beating the stock market have a way of losing their mojo as time goes by. As the payoff from a formula becomes general knowledge, a growing horde of gamers jump on the bandwagon. Amid the groundswell of competition in the field, it becomes increasingly difficult for any single player to reap the rewards in a consistent fashion. On the upside, though, the Timing System has proven to be remarkably resilient. In fact, the technique has long reigned as one of the most potent schemes in the armory of investment methods. The punchy performance was showcased over the course of a decade ending in December 2009. Based on the broad-based benchmark of 5,000 stocks covered by the Wilshire index, the Timing System trounced the passive ploy of buy-and-hold for by 4.5% per year on average (Hulbert, 2010). Another compelling trait lay in the fact that the portfolio was completely out of the market more than half the time. As a result, the calendar scheme delivered more profit at less risk than the baseline ploy of buying stocks and holding them forever.

Dealing with Transaction Costs

On the downside, the Timing System requires a fair amount of trading, along with the transaction costs entailed. In a recent application of the methodology, the investor had to make 17 round trips into the stock market each year. One way to keep a lid on the cost of trading is to use a set of linked accounts within a family of funds. For instance, a pair of efficient pools might allow for the free transfer of cash back and forth between an index fund and a money market trust. In that case, the moola could move easily between the interest-bearing account and the equity pool without incurring any kind of surcharge. Another way to implement the calendar scheme is to use an exchange traded fund (ETF) which tracks a benchmark of the stock market. A case in point is the index fund for the Standard & Poors yardstick of 500 giants in the stock market. The ETF trades on the U.S. bourse under the ticker symbol of SPY. A variation on the theme involves the exchange traded fund based on the index of 100 leading stocks on the Nasdaq exchange. The vehicle trades under the call sign of QQQ. On a negative note, though, an ETF is bought and sold through an equity account just like any other stock. As a result, each transaction entails a commission to the brokerage firm. By contrast, a professional trader might take up a different approach altogether in implementing the Timing System. In this light, an alternative scheme involves the use of a derivative product on the futures market. The punter could take up one or more futures contracts in order to track a benchmark such as the S&P 500 index. Meanwhile the cash in the trading account would be safely parked at all times in the form of interest-bearing assets such as long-term bonds issued by the U.S. Department of the Treasury. The low-risk securities would serve as collateral also

known in the trade as the margin to back up the exposed positions in the futures contracts. A prime advantage of the foregoing scheme is the liquidity, efficiency and convenience of round-the-clock trading available on the electronic platforms designed for the futures market. Another allure for the short-term trader lies in the favorable treatment of income tax on profits earned through futures contracts; the rates are lower than the corresponding values for basic instruments such as common stocks. On the downside, though, the futures market is a fast-moving field that trips up and knocks out many a newcomer. For this reason, the treacherous domain is thoroughly inapt for the mass of investors.

Calendar Patterns for Earnest Investors

As we have seen, trading with the calendar comes with a gaggle of advantages and a smattering of liabilities. On the downside, most investors have neither the time nor the interest in weaving in and out of the market more than a dozen times a year. Even so, taking advantage of cyclic patterns is largely a matter of degree rather than category. Put another way, the use of market templates is not a question of all or none. Rather, the shrewd player can rely on the motifs in a supporting role within a larger program of investment. An exemplar lies in the shunt of funds into an asset in times of weakness rather than strength in the marketplace. For instance, the investor could make a habit of funneling fresh funds into the stock market around the third week of the month rather than some other portion of the calendar. By the same token, a flagging stock ought to be sold just before a holiday rather than a few days afterward. In these ways, the canny investor can move in and out of the market in tune with the currents at large. The dandy routine perks up the average return on investment by a
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modest amount. The impact is to boost the risk-adjusted gain over the long haul without giving up anything in return.

Wrapup for Market Timing

To sum up, the stock market displays a potpourri of persistent patterns over the course of the year. For this reason, a trading strategy based on the calendar can raise the gain while cutting the risk. Granted, the timing technique does have its shortcomings. A case in point is the need to dart in and out of the bourse more than a dozen times a year in order to exploit the patterns to the max. Another snag for the frequent trader lies in the hefty rates of income tax resulting from short-term capital gains. On a positive note, though, the practice of timing the market does not have to be an binary choice between all and none. Instead, the wily player can take advantage of recurrent patterns as an adjunct to a larger program of investment. In fact, the vast majority of investors will have neither the time nor urge to weave in and out of the market once or twice a month. Instead, the astute player can make a habit of committing fresh funds to a portfolio when the market tends to sag. Later on, when the time comes to unload a position, the stake can be sold when the market is likely to reach a high note. By these means, a trading program based on the calendar can bag higher returns at lower risk than the default policy of buying stocks and holding them till kingdom come. For this reason, a timing strategy based on monthly cycles and market holidays constitutes a free lunch in the stock market.

References
Fosbacks Fund Forecaster. The Seasonality Timing System. https://www.fosback.com/seasonality_system.htm tapped 2012/6/8. Hulbert, M. Timing System Gone, Not Forgotten. 2003/1/8. http://www.marketwatch.com/story/timing-system-gone-but-not-forgotten tapped 2012/6/11. Hulbert, M. Trading the Calendar. 2010/2/4. http://www.marketwatch.com/story/updateon-highest-ranked-timing-system-2010-02-04 tapped 2012/6/8. Kim, S. Market Cycles. http://www.mintkit.com/market-cycles tapped 2012/6/15. Wikipedia. Stock Market Cycles. http://en.wikipedia.org/wiki/Stock_market_cycles tapped 2012/6/15.

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