October Effect - Fact or Fantasy?
October has gained a reputation for stock losses. The notoriety comes from the perception that October is the month of stock market crashes, including the Panic of 1907, Black Tuesday (1929), Black Thursday (1929), Black Monday (1929), Black Monday (1987), and Financial Crisis debacle (2008). Note that three of the six biggest stock market crashes occurred during 1929, coinciding with the start of the Great Depression and the 20-year structural stock market bear market.
The October effect remains one of the more popular seasonality indicators. Although market volatility tends to increase in October, the statistical evidence does not support the infamous seasonality phenomenon that stocks crash in October. The October effect seems to be anchored by psychological expectations rather than actual statistics. It appears many investors are creatures of habit and will remember the dates of some of these previous stock market crashes.
If October is more perception than an actual occurrence, October may offer astute investors an opportunity to buy stocks during the market pullbacks. Historically, September is the worst month of the year. Oddly enough, September and not October recorded more frequent drawdowns. Since the 1950s, October came in as the seventh-best month of the year for the S&P 500 Index. Additional studies show October marks the end to corrections and bear markets rather than the beginning of new bear market downturns. Since investors continue to view the month cautiously, it is an opportunity for contrarian or long-term buyers to buy stocks.
Another interesting point worth mentioning is about October. The triggers that created the 1929 crash and the 1907 stock market panic sell-off occurred in September and earlier. The 1929 Crash began in February when the Federal Reserve banned margin-trading loans and hiked interest rates. In 1907, the panic occurred much earlier during March. Earlier in 1907, the lack of confidence from investors in trust companies due to their high risks and relaxed regulation culminated in the run on the trusts during October.
The key takeaways about the October effect are as follows: It is a psychological phenomenon and not an actual occurrence. Although the October effect remains popular, the seasonality anomaly is primarily a psychological expectation rather than an actual occurrence. Seasonality studies also solidly refute the theory October is a crash month. Surprisingly, the October effect seemed to have largely disappeared over the past decades.
The latest dip in the stock market has investors questioning whether a stock market crash will occur in 2021? It is difficult to predict any stock market crash and equally challenging to time the call. Yes, some market downturns have indeed occurred in October. But markets have also crashed in months other than October.
Like death and taxes, another market crash will one day occur again. Stocks remain overvalued for a long time, even after the pandemic-induced market sell-off from last year. The structural bull that began in May 2013 is only eight years young. In the past two centuries, structural bulls in the U.S. sustained for eight to twenty years. The average is around fourteen years. If the structural bull trend ends this year, it will be one of the shortest structural bulls in U.S. history.
Technically speaking, bear markets tend to display the following classic signs: (1) buying exhaustion; (2) lack of market breadth; (3) high speculation; (4) topping patterns or distribution-type formations such as head/shoulders tops, rounding tops, large descending triangles; (5) rolling of key moving averages (50-day and 200-day ma); (6) major trendline breakdowns; and (7) violations of key Fibonacci retracements.
Head and shoulders top formations developed across key market indexes over the past few months. However, in the past week, the market actions suggest these distribution patterns are negated. The ability to surge above the respective left/right shoulders reverses the topping formations. A convincing move above the head further reaffirms the negation of the market tops and signals the next market rally. With seasonality strength around the corner, does the negation of the head/shoulders tops ignite the year-end to early-2022 rally?