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Watch out investors: 'Herding' may mean rocky markets ahead

George Athanassakos

Fred Lum/The Globe and Mail

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.

As summer recedes and it's back to the grindstone, an investor's thoughts turn once again to the issue of seasonality.

September and October are seasonally weak months for stocks (and seasonally strong months for government bonds). But not always. In general, what determines the weakness of stocks in these months depends on how strong the first few months of the year are. If the first quarter is strong, September and October tend to be weak months and vice versa.

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The U.S. stock market was up by more than 10 per cent in the January to July period. The European and emerging markets were up more than 20 per cent. On the other hand, the Canadian market flat lined over this period, weighed down by oil, material and bank stocks. If my statement in the second paragraph is correct then we should observe weak stock markets in the United States, Europe and emerging markets in September and October and possibly the rest of the year, and to a lesser extent in Canada, as the Canadian market tends to move in sympathy with the United States most of the time.

Such expectation is driven by my belief in the so-called "sell in May and go away" effect – the historical underperformance of stocks from May to October in relation to November to April. But this is true on average, not every year.

Let me explain.

The "sell in May and go away" seasonal pattern, in my opinion, is driven by the conflict of interest professional portfolio managers face when they manage other people's money and by human psychology.

Professional portfolio managers' agendas and their efforts to maximize their own benefits lead them to rebalance their portfolios in a predictable way throughout the year.

The high returns on risky securities around the start of the year are caused by systematic shifts in the portfolio holdings of professional portfolio managers who rebalance their portfolios to affect performance-based remuneration (i.e. their Christmas bonus). Institutional investors are net buyers of risky securities around the new year when they are motivated to include less-known, high-risk securities in their portfolios and are trying to outperform benchmarks.

Later on in the year, portfolio managers lock in returns by divesting from lesser-known, risky stocks and replacing them with well-known and less risky stocks or risk-free securities, such as government bonds. Such behaviour affects prices and security returns in a predictable way. Risky stocks and high-risk bonds are bid up early on in the year and down later on in the year, whereas low-risk stocks and government bonds reflect the opposite behaviour – down early in the year and up later.

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As arbitraging is taking place by those investors not bound by the restrictions or conflicts portfolio managers are facing, the pressure on stock and government bond prices is spread over a few months, giving rise to stock-market relative strength in November to April, and relative weakness in the May-to-October period – and the opposite effect for government bonds.

What amplifies this seasonal pattern is that professional portfolio managers exhibit the very human trait of herd mentality. They are safe when their portfolios look similar to those of other portfolio managers who invest with the same mandate – no one loses his/her job because of average performance or holding the same securities as the rest of the peer group. This is particularly true since the survival of professional portfolio managers is based on short-term performance metrics.

Research has shown that herding is especially strong in smaller stocks, growth stocks and emerging markets. This year in particular, portfolio managers – having done quite well in the United States, Europe and emerging markets – may be inclined to play it safe. Why should they risk it and stay in the market given the geopolitical and financial headwinds, as well as policy uncertainty in the United States? The safest option for them, the herd, is to sell risky securities and stay in cash or rebalance toward government bonds and wait the market out by locking in their good performance and their Christmas bonus. This is, in my opinion, what is and will be affecting stock markets in the September-to-October period and perhaps for the rest of the year.

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About the Author
Finance Professor

George Athanassakos is a finance professor and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario. More

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