Stock Market Seasonality: November Strengthens Market Performance
As the year comes to a close, discussions regarding stock market seasonality are gaining traction, and for good reason. Since 1950, November has consistently been the strongest month in terms of stock market performance. The two-month period from November to December also boasts the highest average returns, according to LPL Financial.
This remarkable strength in the stock market during November follows a historically weak September, which has typically been the worst month for stocks. In line with these patterns, the S&P 500 fell by 5% in September and subsequently rose by 4% in the first few days of November.
Various theories attempt to explain the seasonality of the stock market. For instance, the chilly weather in September is believed to dampen traders’ sentiment, while the end of summer vacations on Wall Street leads to increased selling. Another theory attributes the year-end strength to the spread of holiday cheer and the subsequent increase in consumer spending on gifts, which encourages more buying than selling. This phenomenon is often referred to as the “Santa Claus rally.”
However, one driving factor behind stock market rallies has more concrete evidence supporting it. Mutual funds are subject to a quirk in the tax code that has significant implications for the market. Specifically, mutual funds must complete their tax-loss harvesting trades by October 31, three months ahead of the deadline for retail investors. Tax-loss harvesting is a trading strategy used to reduce tax liability.
According to Savita Subramanian, an analyst at Bank of America, the Tax Reform Act of 1986 mandated the October 31 cutoff for most mutual funds to realize capital gains, leading to the increasing prevalence of tax loss harvesting among institutional investors. Considering that US mutual funds manage over $20 trillion in assets across stocks and bonds, this practice can have a substantial impact on the markets.
Tax loss harvesting involves selling stocks that have experienced year-to-date losses and waiting for 30 days before repurchasing them to avoid violating the wash-sale tax rule. Mutual funds can then use these realized losses to offset their tax liability when they sell winning stocks in the future. Subramanian notes that evidence of tax loss selling by institutional investors in October, followed by a reversal in subsequent months, has been observed historically.
The reversal of tax-loss selling can help drive stocks higher towards the end of the year, especially when numerous stocks have experienced losses throughout the year. In 2023, while the S&P 500 has increased by approximately 14%, half of the companies in the index are down, with over a third experiencing declines of over 10%.
Stocks that qualify as tax-loss candidates have a tendency to rise after October 31, which ultimately contributes to the broader stock market’s upward movement. Subramanian reveals that, on average, stocks down 10% or more from January 1 to October 31 have outperformed the S&P 500 by an average of 1.9 percentage points over the next three months, with a 70% success rate.
With the tax-loss selling period for mutual funds now behind us, there could be upward pressure on stock prices as these funds start buying back the shares they recently sold. This aligns perfectly with the bullish seasonality that typically characterizes the year-end market.
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