We all know the phrase self-fulfilling prophecy. In the Cleveland Clinic’s words: “Self-fulfilling prophecies occur when a prediction brings about its own fulfillment. In layman’s terms, that means that if you believe something to be true, you’ll act as if it were true. And your actions double down on your prediction to make it a reality.”
Why the Cleveland Clinic has an opinion on such things is anyone’s best guess. However, it seemed to be a much more reliable and intellectual source than Wikipedia.
The reason why I start with this thought process is because September has historically been the worst month of the year for stocks. While there are any number of reasons for this, the most often used is the nebulous ‘seasonal factors’ or ‘seasonality.’
It is just what happens at this time of the year. When the leaves start falling, expect stocks to do the same. Except that isn’t always the case, and it doesn’t necessarily apply to all stocks. Just stocks, in general, and all other things being equal, knowing full-well they rarely are.
But why September? As John Blutarsky might ask: “why not?”
The September Effect
I hate to admit it, but Investopedia might have the best, most succinct reason why the start of fall leads to red ink in the markets. The so-called September Effect. No, it isn’t because investors are despondent over their children having to go back to school. Nor do people tear at their clothes because the Demon Deacons won’t win the NCAA football championship.
However, returning after summer vacation might actually have something to do with it.
You see, a lot of institutional portfolio managers (i.e., active mutual fund managers, large pension plans, foundations, endowments and the like) often take the month to determine how to best position their funds for the end of the year.
After all, everyone will have used vacation time over the summer, and it will be time to get back to work.
In September, investment professionals around the world will decide which stocks to sell to ‘lock in’ performance relative to the benchmark. Then, they will offset the realized gains with losses from underperforming holdings. Basically, out with the high-flyers and dogs, and in with index funds and cash.
The October Anomaly
That is until October. In October, these same managers will buy back their positions after the 30-day wash rule expires. At that time, anyone still sitting on cash will jump back into the market in a FOMO trade. After all, no one wants to lose ground relative to the index so close to the end of the year. That is how one loses their bonus or even their job.
If nothing else, they will just buy the SPY exchange traded fund or some such equivalent. When I write there is/are literally hundreds of millions of dollars in incentive pay at stake, folks will do what they need to do in order to get as much as they can. If it means having a 8% in Apple up through Labor Day, selling it to lock in the return and then buying an index weighting back in October, then so be it.
This happens every year, much like the march of the penguins and the great wildebeest migration. I guess you can say it is somewhat animalistic and instinctive in that regard.
This begs the question: if everyone knows this is going to happen, couldn’t you just take the opposite side of the trade and crush it? You know, like stealing the orange crop report from Clarence Beeks? That seems to make sense.
To be sure, some people will do that. However, and this might sound crazy, the genesis of the September Effect is taking risk off the table. Not adding to it. Managers are trying to lock in their return relative to the benchmark, not necessarily double it.
You can think of it as running the ‘prevent defense’ during the 4th Quarter when you are up a couple of touchdowns.
Just keep the ball in front of you, and don’t let them score. Run the clock, and don’t do anything stupid. Exchange yards for points, and all of that good stuff.
If you hate the prevent defense, and a lot of people do, imagine what happens when a wildebeest in the middle of the pack starts to run against the grain. If not that, what happens if they just step to the side, away from the protection of the heard?
The odds are they will either get trampled by their own or eaten by predators.
This might sound crazy, but your highly paid portfolio managers at massive mutual fund companies aren’t always going to be your biggest risk takers. My experience has been they usually aren’t. However, they are very analytical, intelligent and clever people. If their bonus maxes out at, say, 150% of their benchmark bogey, they won’t stick their neck out to make 300%.
Why would they? They aren’t playing with their own money. There isn’t any more upside for them. However, they will do anything they can to get to that 150%, if it is possible. Trust me, I have been there and done that sort of thing.
That takes me to the last question I will ask myself for the day? Why September? Why not October or even November? There would still be enough time to get things done by the time the ball drops in Times Square, right?
OK Back to September. Why September, John?
There are a couple of potential answers to that question, and I will start with the weaker answer.
By doing these trades in September, institutional investors have a couple of months to make any other trades they need to make to catch up to the benchmark.
Since these will typically be buys, you want to be “all in” to take advantage of the underperforming firms which are trying to catch up to the market. Essentially, you want to be fully invested to take advantage of those playing catch up.
That is the first plausible answer, and it is the weakest. The far stronger argument is the following, which is decidedly more succinct.
It is sort of a self-fulfilling prophecy sort of thing. You know, it is just what happens in September.
Yeah, I know. Hey, can anybody queue up that Greenday song for me?
John Norris
Chief Economist
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this any every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
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