History cautions against September market re-entry

SERIOUS MONEY:INVESTORS WHO obeyed the old stock market maxim, "Sell in May and go away", have side-stepped the vicious downturn in equity prices through the summer and early autumn.

Global stock market indices peaked on the first trading day of May and have since dropped by almost 20 per cent, as a sharp slowdown in economic activity across the developed world, alongside the never-ending euro zone sovereign debt crisis, shook investors’ bullishness.

The major market indices have endured a near bear market decline, as a relentless stream of disappointing news has been digested, so it is reasonable to ask whether it is safe to reverse course and establish long positions. The trusted market adage advises investors to throw caution to the wind and, “come back on St Leger day”, the date of the world’s oldest classic horse race.

The St Leger Stakes was run at Doncaster last Saturday but, the historical evidence – coupled with reliable leading indicators – suggests that investors may well be better-served to remain on the sidelines for now.

September has typically proved difficult for investors and, it is the only month to have generated a negative mean return through time. The mean return has been minus 0.25 per cent since 1802, and the seasonal effect has shown little sign of becoming less pronounced in the recent past. A dollar invested in the stock market in the month of September since 1971, would be worth less than 70 cents today or just 12 cents in real terms.

The historical record demonstrates that the economy and financial markets have been particularly crisis-prone this time of year. Cash has typically generated higher returns than the stock market across the months of September and October.

Historical crises that struck this time of year include the Panic of 1819, the first major financial crisis in the United States; the Panic of 1857, which was triggered by the failure of the Ohio Life Insurance and Trust Company; the Panic of 1873 that followed the collapse of Jay Cooke Company; the run on the Knickerbocker Trust and the subsequent Panic of 1907; not to mention the Great Crash of 1929.

More recent episodes include Black Monday in 1987, the United Airlines mini-crash of 1989, the 1997 attack on the Hong Kong dollar, the terrorist strikes on the World Trade Center and the Pentagon in 2001, and, of course, the Lehman Bros bankruptcy in 2008.

Those of a bullish persuasion will undoubtedly argue that the historical record is purely coincidence and thus of little value to tactical decision-making. That may well be true but it is important to stress that recent market action has been accompanied by a whole host of indicators that give pause for thought.

First, both 10-year Treasuries and German bunds are trading at record low yields – below 2 per cent – which is simply not consistent with continued growth in the developed world. The respective yield curves may well have a positive slope but the spread between short-term and long-term interest rates loses its usefulness as a leading economic indicator when short-term rates are close to the zero-bound.

The actual level of yields, at a five- to 10-year horizon, suggests that a recession in the euro zone and the US is imminent.

Second, the cost of corporate credit is rising and the recent widening of high-yield bond spreads from an average of 440 basis points in April to more than 730 basis points in recent weeks, warns of an impending downturn. Indeed, a recession typically follows whenever the spread is sustained above 700 basis points.

This indicator did send a false signal in the latter of half of 2002 as an economic downturn did not subsequently materialise. However, this did not protect equity investors who endured a devastating decline in stock prices.

Third, leading economic indicators such as copper prices are in the process of breaking down, while the demand for safe haven assets such as gold, the Japanese yen, the Swiss franc, and even the dollar, is strong. Furthermore, bank share prices are crumbling worldwide and funding costs are under pressure. It is clear that stress is building throughout the financial markets and tail-risk is rising.

Mark Twain quipped in his 1894 novel, Puddnhead Wilson that “October . . . is one of the peculiarly dangerous months to speculate in stocks”.

The truth of the matter is that both September and October have proved to be notoriously tricky for equity investors and, early indications are that the seasonal pattern looks set to be no different this year. Tail-risk is rising as economic growth falters and the euro zone sovereign debt crisis moves closer to the end-game. Caution is warranted for now.

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