Download Seasonality of Stock Market Returns

College of Business Administration
FINA 3312: Financial Markets and Institutions
Section: 201
Seasonality of Stock Market Returns
Sarah Sultan – 201000073
Lulu Al-Fayaheen - 200600515
Fatimah Al-Shawaf - 200801492
Instructor: Dr. Rashida Sharmin
Fall 2012
December 19th, 2012
Executive Summary:
Millions of people worldwide are connected to the stock market in one way or another.
That said understanding the seasonality effects of stock market returns is essential. The stock
market consists of individuals who are interested in having some kind of ownership of a firm or
corporation. These investors invest their money into these businesses in order to receive some
returns at a certain maturity date depending on the future of the company’s performance.
Seasonality in short terms, is the expected variations or changes to the calendar or time of day.
There are several seasonality phenomenon’s’ that will be discussed thoroughly in the
coming sections that without a doubt affect the returns of the stock market. This will also include
the adverse affect of the investors involved in that given stock market. There is a direct
relationship between stock market returns and seasonality. And for that reason exactly, it is really
necessary to understand and analyze the different kinds of seasonal variations that ultimately
affect the returns of the corporation and investors.
Introduction:
The stock market is a public unit in which investors exchange their funds for a share of
ownership. The whole purpose of a stock market is to provide companies and large firms with
funds in order for them to continue their operations and expand. However, in return, these firms
must sell some shares of ownership. The funds are provided by investors who are interested in
receiving some sort of return at the end of a certain maturity date. At times, the stock market may
face some seasonal variations, which would directly affect the investors’ willingness to continue
their relationship with the company they have funded. That said some investors choose to sell
their shares to ensure they won’t lose anything. When stock prices drop, the returns will also
decrease which would affect the issuer of the shares as well as the investors in a negative
manner.
The stock market is such an important part of the economy because it is said that if the
stock market is doing very well the economy in return will also grow. There are a few seasonal
phenomenon’s’ that affect the stock market returns. The January effect, Monday effect, Holiday
effect, announcements effect, small-firm effect as well as turn-of –the-month effect are all
examples of seasonal variations that are very well known and recognized by millions of investors
around the world. Understanding these various seasonal effects will help determine the stock
market returns.
Efficient Market Hypothesis:
To start off, we would like to introduce an investment theory that has been a controversial
theory over the past decade. This theory is known as the efficient market hypothesis. This
hypothesis clearly states that the market prices of assets should always be equal to the projected
or estimated values, because all the information needed for investors is present. It also states that
in an efficient market the prices of stock should always be correct as well as reflect market
fundamentals. Market fundamentals are those elements that have a direct impact on the future
income flows of the securities. That said, this theory suggests that at all times the shares that are
being traded are always at a fair value and that it is impossible for an investor to buy an
undervalued stock or even sell a stock that has an inflated price range.
In fact, this hypothesis also states that as new information comes up, within a short time
the news will spread to all the investors. Thus, the prices of the securities will change
automatically. Therefore, any seasonality or timings should not affect the market’s performance.
In the coming sections, there will be several common seasonal variances that contradict the
efficiency market hypothesis. A perfectly efficient market contains the information about
companies that is perfectly accurate as well as published on time with no deficiencies. As we all
know, the stock markets around the world are not perfectly efficient due to unethical
corporations and firms who at times trick people by distorting the actual share values and
deceiving people into owning their shares.
Seasonality:
The term seasonality is extremely broad. However, it’s relation to the stock market’s
returns are directly related. For when there is some kind of irregular activity As stated previously
seasonality is the short term, however regular variances that occur over the course of a year.
Whether it’s a change due to the month of year or even due to a holiday or announcement, these
changes can definitely affect the returns on the stock market. The January effect, Monday effect,
Holiday effect, announcements Effect, turn-of-the-month effect, small-firm effect, and finally
weekend effect are all examples of seasonal irregularities. Each will be spoken about in depth.
As mentioned, seasonality is a broad idea that not only affects the stock market returns but it also
can have an immediate effect on the manufacturability of a company, operations, various
business cycles, and many other areas as well.
Being aware of these seasonal trends that are at times obvious is an important part of the
investing process. Investors need to know about all kinds of information whether good or bad
about anything that could affect the share value. No one wants to lose money, or be put into a
position where they can’t sell off their shares because it has become undervalued.
The Seasonal Patterns:
The concept of seasonal pattern comes from the fact that, not the cycle of seasons can be
traded, but a single seasonal pattern can be. From this fact came the definition of seasonal pattern
as an a seasonal movement that cannot be identified between two dates. But what could be done
is, identifying the high events probability, timeliness, and a solid reason for these movements.
Seasonal patterns can differ in length between short, medium, or long terms but they can still
overlap with each other. This usually allows conclusions to be made in form of statistics in order
to connect with one seasonal pattern. For example, during the summer months, usually oil prices
go up, and more people go on vacations and use their cars more frequently. As such, oil stocks
make the list of seasonal if the stocks when are bought in the spring and kept until September,
when they are making positive returns on investment, they make results more than the oil price
rise
Turn-of –the-Month Effect:
One of the seasonality effects that affect the stock market returns is the turn- of- themonth effect. This is basically a temporary incline of stock prices. The increase of stock prices
usually occurs around the last days and the first few days of the given month. It was stated that
some stock market analysts believe that this effect is due to the immediate distribution of both
pension funds as well as retirement funds that are reinvested into the stock market. An example
that proves this seasonality effect exists is that it was stated that S&P 500’s gains were due to a
seven-day period. These seven days consisted of the last four trading days of the month and the
first three trading days of each month. That says, that at the turn of each month stock prices
increases which reports capital gain. In this specific example, the seven days actually represent
almost 1/3 of the trading days of that month. During the other days of the month the stock market
lost money.
This effect significantly affects the stock market returns. It was stated that since the year
1987 till present day the average daily value-weighted of excess market return due to the turn-ofthe-month effect is approximately .24%. The other 16 trading days have an average of .04% of
excess market return. As you can see there is a significant difference in the stock market return.
However, it was mentioned that the standard deviation or the return variability is not different
from the turn-of-the-month days when compared to the other trading days. As mentioned
previously, this effect is only referring to capital gains and not dividends. As we have learned
the returns on stock markets are from the dividends. That said, if investors are only willing to
invest during the turn-of-the-month, it is clear that market returns will drop dramatically in the
other 2/3s of the month.
The graph below is a simple line chart that represents how the turn-of-the-month looks like:
Here is an average of the daily gains:
Standard
Day
Daily Gain
Fourth to Last
0.068%
1.064%
Third to Last
0.021%
1.055%
Second to Last
0.071%
1.037%
Last
0.088%
0.997%
First
0.118%
1.117%
Second
0.168%
1.065%
Third
0.155%
1.077%
Deviation
Small-Firm Effect:
Another seasonality effect that we will discuss is the small-firm effect, which is also
known as the “white cap effect”. This effect assumes that at times there are smaller firms or
companies that have little market capitalization, however, these firms tend to do better than
larger firms. Market capitalization is simply shares outstanding multiplied by share price. How
does it affect market returns, the idea is fairly simple. Research has proved that smaller
companies are beating larger companies for hundreds of years. Let’s take Wal-Mart and
Microsoft for example. These two enormous companies started off as small companies. How did
they beat the larger companies when they first entered the market. Well, the small-firm effect
must follow certain criteria in order to successfully receive higher returns than the larger
corporations. Firstly, the company must provide a product that satisfies unmet market needs.
That said, their product must be unique, and the product should be new to the market. Another
factor is that the small-firms should have low debt. Debt can put a huge strain on the
shareholders value. As debt increases so does the shareholders value. Minimizing debt is a must.
The next factor is that there should be low competition and at the same time there should be high
barriers to entry.
It has not yet been proven the reasoning behind why at times smaller firms outperform
larger firms. However, many financial analysts believe it is all about the risk a firm is willing to
take.
Weekend Effect:
Another phenomenon that we will discuss is the weekend effect anomaly. This
irregularity has been a constant pattern in the performance of the stock markets since the early
1980s. Traders in the stock market have realized that the securities have a tendency to perform
very highly on Fridays. This trend suggests that there is a downward average of stock market
returns from Friday to Monday. The reasoning behind this trend is because companies at times,
release negative news that can affect the value of stock on late Friday afternoons. This bearing of
bad news automatically affects the trader’s interest in investing in certain companies. This
ultimately creates decrease in the stock market returns. Traders in the stock market keep a close
eye on any information that could be related to bad news.
As mentioned earlier, this irregularity does not happen every weekend. At times, months
can pass by without the seasonality of the weekend effect. However, due to the history of the
stock market, people are now aware of the reasoning to why at times during Friday through
Monday there is a negative effect of the stock market returns. The weekend effect is still a
controversial topic and there are many reasoning’s to why the returns could decrease during
those specified days.
Holiday Effect:
The holiday effect refers to “The higher returns around holidays, mainly in the preholiday period as compared to returns of the normal trading days” (Sulaim, 1991). The concept
of the holiday effect was reached by long time observation of stock market that showed half of
the positive returns happen during the 10 trading days before the holiday every year. This
observation was clear in the US stock market that showed in 8 trading days before a market
closing for holiday that more than one third of positive returns were registered.
Announcements Effect:
An earnings announcement that follows the end of each quarter, on asset pricing has a
regularity of seasonal. The proof that a seasonal effect can happen due to announcement, can be
done by linking earnings announcements to liquidity effects, which should show that earnings
that lead to liquidity shocks. There are many studies that show that around any sounding
announcement the bid-ask spreads becomes wider, and also the depths on the limit books greatly
decreases, and trading volumes fluctuates in sharp way and that is decreased right before the
announcement and surging right after that (Itzhak, 1996). Most authors conclude that “the
observed patterns are best explained by the changing information environment around these
events”(O'Hara, 2003).
Various Month Cycles:
Among the several seasonal stock market trends that the investors should know so that
they can capitalize, are those that bring profits on short term. These are the trades the hedge
funds and the institutional investors, as high operatives that the individual traders can take the
advantage from them as seasonal stock market patterns to. The best months for stock arranged
from top to the bottom, are July, January and December.
July: Considering the public activities like returning to school and to the shopping seasons, July
is the best. The reason is that, people have good hope before any major holidays in this month of
July.
January and December: On the other hand, are the second to best for seasonal stock market
patterns because of the fact that, in January many retailers would want to report their holiday
sales capitals for the nest quarter. January retailers, usually have a list with the best seasonal
stocks when holiday is about to end.
December: Is very exceptional as month for stock capitalization in seasonal stock market trends.
It is because the traders under the effect of December and they want toget rid of their loss
situation in this month of December even though the change will not be big enough with
compare to years of losses that is usually big amounts. That is why the investors become in a
hurry to make up for their loss in December before the year ends.
The last few trading days of the month:
Generally speaking, the first and the last few trading days of the month are usually lousy
days for the stock market players because they are open for seasonal stock market trends. The
first and the last invest may give way to employees’ retirement plans causing moves like getting
and giving salaries and also a small amount of money that is flowing between the mutual
funds and into the stock market. The size that results from such social funds is great enough to
affect the return of the first two and last two days two days of the month that may reach .15%
everyday.
Conclusion:
In conclusion, the stock market as a whole does not perform perfectly efficient at all
times of the year. There are some many expected patterns of variation in the pricings of stocks
due to several seasonal irregularities. The stock market returns can vary from time to time. This
report provided a few examples of the different kinds of seasonal phenomenon’s that could
change the pricings of stock, as well as the stock market’s performance as a whole. Investors
should think and act quick when such variations are present while they are holding their shares.
In order to do so, having the right information at the right time is one of the most important
techniques of being a smart investor. Also, investors should not put all their confidence in one
investment. However, they should spread their risk, and invest in more than one firm. As we all
know don’t put all your eggs in one basket, because they might get crushed.
References:
Weekend Effect. (n.d.). Retrieved December 16, 2012, from Investpedia:
http://businessinnovation.berkeley.edu/WilliamsonSeminar/hamilton041609.pdf
Elfenbein, D. (n.d.). The Small Firm Effect . Retrieved December 10, 2012, from Berkley:
http://businessinnovation.berkeley.edu/WilliamsonSeminar/hamilton041609.pdf
Seasonal Stock Market Trends. (n.d.). Retrieved December 4, 2012, from Wiley:
http://eu.wiley.com/WileyCDA/WileyTitle/productCd-0470270438.html
Stock Market. (n.d.). Retrieved December 5, 2012, from Investopedia: http://financialdictionary.thefreedictionary.com/Stock+market+returns
Stock Market Cycles. (n.d.). Retrieved December 12, 2012, from Stock Screening 101:
http://www.stockscreening101.com/stock-market-cycles-seasonal.html
Stock Market Returns. (n.d.). Retrieved December 4, 2012, from Financial-Dictionary:
http://financial-dictionary.thefreedictionary.com/Stock+market+returns
Kovacs, T., (2005), Intra-Industry Information Transfers: Evidence from Earnings
Announcements, Working Paper.
Itzhak, L., (1996), Earning Announcements and the Components of the Bid-Ask Spread,
The Journal of Finance 51, 13