Forget a Crash: 16.3% Returns are Possible in October

October is a perilous month in order to trade stocks…

The other dangerous trading months are July, January, September, April, November, May, March, June, December, July, and February.

Mark Twain made this well-known observation around 1894. It appears the actual creator of Tom Sawyer and Huck Finn did not hold stocks within high regard.

Twain made a lot of money from his writing. But as an investor he was much less successful. Several failed endeavors lead to bankruptcy. Perhaps this particular explains his cynical comments on stocks.

One thing stands out to me. Twain singles out October for a special mention. As well as he’s not alone. The 10th month of the year has a track record of trouble.

There is some substance behind the fear of October. This particular month has seen some of the biggest market crashes. The three large ones were in 1929, 1987, and 2008.

So should we be fearful of a crash each October?

Well it’s interesting. Humans have a tendency for selective thinking. We notice events that support our beliefs, and we filter out those that challenge them. Psychologists call this confirmation bias.

Yes, Oct has seen some big drops. The media reminds all of us of this each year. This builds upon the notion that October is really a risky month. But could it be more so than any other 30 days?

Well, there is only one way to find out — let’s have a look at the data. I’m going to start with a table. This shows the average monthly performance for the S&P 500 since 1950.

Source: Moneychimp.com

October isn’t therefore bad. The average return associated with 0.7% makes it the seventh most profitable month. Actually, October has been up 62% of times — that puts it in fifth place.

Now let me split it down a bit further. There is more to an typical than a single number. The composition of this figure could be reveling.

October’s worst results were in 1987 as well as 2008 — the market fell 21.8% and 16.8% respectively. These are far from the typical result. They are outliers — statistical long shots.

We also need to consider the upside. This is an important part of the story.

October’s best results are 16.3%, 11.1%, and 10.8%. The only other month to have three double-digit gains is January. Most months don’t have any double-digit gains at all.

The other point to make is the size of the actual returns. October’s 16.3% rise in The 1974 season is the biggest of any 30 days. The closest figure is 13.2% in January 1987.

An explanation for this strength is that October follows the seasonal fragile months. Take the gains of 16.3% and 10.8% for example. Both followed sharp Sept sell-offs.

You could call October the actual rebound month. The next few weeks could be interesting.

It’s funny how we only hear about October’s crashes. Hardly ever does anyone mention the actual rallies. And that’s confirmation bias in action — focus on one side, and filtration system the other.

The message is clear. It can make no sense to sidestep October.

Seasonal swings

You may remember a study I wrote a few months ago. It was about an age-old market adage: Sell in May and go away. The idea is to avoid the period between May and Oct.

Let me briefly recap…

The saying dates back to a bygone era. It was a time when the nobility ruled the market…and their sociable calendar had a big affect on stocks.

You see, May had been the start of the summer social period. There was sport to watch as well as lawn parties to attend. The marketplace lost its most energetic players.

With the big money on the actual sidelines, trading volume would dry up. This had a inclination to increase volatility. The safest bet was to sell and are available back at the end of the season.

Have an additional look at the above table. You will notice there is a strong seasonal pattern. November to April is actually noticeably stronger than May to October.

So forget about avoiding October. What would happen when we avoided May to October all together? Well let’s perform some testing to find out…

The first chart is probably familiar. It uses Quant Trader‘s entry and exit methods.

Take a look…

Click to enlarge

The start date for the test is 1 November 2005. There is no allocation for the seasonally weak May to October period. The system deals month in, month away.

This strategy performs well. Certain, there are pullbacks along the way. But profits regularly hit new highs — something the All Ordinaries hasn’t done.

Now let’s do an additional test. This time I’ll create a change. The system will only purchase between November and April. It will then exit just about all positions at the end of April every year.

To be clear, this strategy only operates six months of the year. This sits out the May to October periods.

Okay, are you ready for that results? Let’s have a look…

Click in order to enlarge

This is quite amazing. Excluding May to October removes a lot of the volatility. Profits increase in a smooth series of steps.

Go back to the first chart. Look closely at the big corrections. You’ll see they mainly occur during the seasonally weak several weeks. The years 2007, 2008, as well as 2011 are a standout.

But there are other things to consider. Some of the May to October periods are strong — namely 2009, 2012, and 2013. Missing these holds profits back.

I have one more graph for you. This is what the two strategies look like side-by-side…

Click to enlarge

The azure line is the strategy that trades year-round. ‘Sell in May and go away’ is the red line.

It appears selling in May can reduce volatility. But it comes at the expense of higher profits — it is a trade-off.

Selling in May is an fascinating concept. This 10 year snapshot suggests it has merit. But personally, I believe trading whenever an opportunity arises is the best strategy.

October isn’t such a scary 30 days when you look at the facts. Continually be a little skeptical when somebody only tells you one side from the story.

The seasonally weak months are now behind us. It won’t surprise me if the 2015 low is in place.

Until next week,

Jason

Editor’s note: Quant Trader’s algorithms possess detected a number of new opportunities. They are trending higher, and have the potential to run a long way.

You’ll be familiar with a few of the companies. But many are less well known. These are often the ones with the greatest benefit.

The seasonally strong months are now here. Take the next step…see what Quant Trader could do for you.