No matter who you are, there’s at least one thing you like about the last three months of the year.
This is the time of year when holidays cluster. Schools and workplaces close. Families gather to celebrate.
As an investor, I like the fact that stocks deliver their best returns of the year in the last quarter.
In an average year, the Dow Jones Industrial Average and the S&P 500 produce half of their gains in this three-month period. For the Nasdaq Composite Index, the gain in the last three months of the year is about 40% of the annual average return.
Skeptics might question this trend. They may believe there’s no reason for this behavior. But there is.
Swinging for the Fences
Stocks go up when investors add money to their investment accounts. In the fourth quarter, individuals and professionals create demand for stocks.
Individuals might fund retirement accounts as the end of the year approaches. They might also fund educational accounts as news stories about tuition costs scare them into action.
Professionals also buy in the fourth quarter. Annual reports to shareholders list all the positions they own. Managers sometimes take part in “window dressing” to make those reports look better.
Window dressing is a powerful motivation.
Bonuses for hedge fund managers depend on fourth-quarter performance. Better performance means a better bonus.
This is often the time of year when managers “swing for the fences” and make aggressive trades in pursuit of a bonus.
Once again, skeptics might not want to believe something like window dressing exists. Academic studies confirm managers sometimes buy stocks just to show off. But studies confirm this doesn’t really help the managers.
One study concluded: “Window dressers also have poor past performance, possess little skill, and incur high portfolio turnover and trade costs, characteristics which, in turn, result in worse future performance.”
A Time to Buy
Now, since window dressing exists, it can benefit highly skilled investors.
Knowing the fourth quarter could deliver large gains, investors should buy aggressive stocks. If you’re not comfortable picking stocks, buy ETFs that track aggressive indexes.
An ETF is an exchange-traded fund. These are investments that trade, like stocks. An ETF usually owns a collection of stocks, like the stocks that make up the S&P 500 Index.
In the fourth quarter, the best ETF to own is the PowerShares QQQ ETF (Nasdaq: QQQ). This ETF tracks the Nasdaq 100 Index and includes companies like Facebook, Amazon, Apple, Netflix and Alphabet (the parent of Google).
Now, the fourth quarter has also included some of the worst market crashes in history. In October 1987, the Dow fell 22.6% in one day. In 2008, the index declined more than 30% at one point.
Including those losses, history says this is a time to buy.
It will be important to manage risk, but it will also be important to accept some risk. Based on history, now is definitely not the time to avoid the stock market.
Michael Carr, CMT
Editor, Peak Velocity Trader