Investing is a game of probabilities, and while those probabilities are not always clearly defined, sometimes they are. Case in point: year-end rallies.
Let’s say I took an oddly shaped coin out of my pocket and asked you if you’d like to play a simple betting game. You, having never seen such an irregular shaped coin before (and being a savvy investor to boot), say, “Sure, but I want to see that coin flipped a hundred times first.”
Okay, fair enough.
In the course of flipping the coin, you notice that heads come up 73% of the time, and you begin to grin. We proceed to bet, and naturally, you pick heads every time until all of my money finds its way into your pocket.
Feeling rather great about yourself, you saunter off to enjoy your winnings.
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There is a simple lesson here, and also one that is more complex. The simple lesson, as you immediately figured out, is that when probabilities are clearly in your favor, you bet – and when they aren’t, you don’t. In this case, you analyzed historical performance to understand that there was a good likelihood of you coming out ahead, as long as you picked heads each and every time.
But probabilities are not always so clear-cut.
Let’s say we repeated the prior game, except this time, the oddly shaped coin that I took out of my pocket was actually balanced – with a 50% chance of landing heads and a 50% chance of landing tales.
If you took the same approach, wanting to see a hundred coin flips before you bet, what do you think might happen?
I can tell you almost without question that during those 100 flips, a balanced coin would not land 50 times heads and 50 times tales (in reality this would only occur 1 out of every 12.56 attempts – or 8% of the time). So the resulting offset between heads and tails (which would occur 92% of the time) would make it appear as though the coin was unfairly balanced to some degree – making you think you had a slight edge, even though you didn’t.
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For the most part, any deviation from a 50/50 outcome would be slight (getting 51 heads to 49 tails would be more likely than 52 heads to 48 tails and so forth). As we get further away from our expected long-term average, it’s a signal that some type of edge or bias exists in this particular “market.”
Returning to our original scenario, a logical question to ask might be: If a balanced coin were flipped 100 times, what is the probability that it would land heads 73 times?
Well, according to WolframAlpha, that calculation appears as shown below, and the probability of seeing heads 73 times out of 100 tosses is just 1 in 661,146 attempts.
So in our first scenario, the outcome was actually significant enough to ensure with some degree of accuracy that the coin was unfairly balanced. This is ultimately the edge that allowed you to take all of my money. (Please note that this result does not suggest the coin has a 73% chance of landing heads over the long run, only that there is some type of bias to this coin that causes it to land heads more often than tails.)
Okay, so what the heck does all this have to do with investing?
Well, we often see seasonal patterns play out in the stock market, and one of the most prominent of those seasonal patterns is strength in December (as well as the 4th quarter in general).
In the table below, which is courtesy of Yardeni Research, we can see the number of positive and negative closes over the last 89 years by month. Notice that December has the highest winning percentage, closing with gains in 65 out of the last 89 years.
That works out to a “win rate” of 73% … just as in our first example.
If we were to take the (incorrect) stance that markets follow a “random walk,” then we could make the brash assumption that the probability of seeing gains in any given month is 50/50, just like a coin toss.
Continuing down that path, the chance of seeing the market close with positive gains 65 out of 89 times is 1 in 191,872. In other words, it’s extremely unlikely, implying that there is some type of upward bias to the stock market during December.
And that means – you guessed it – make sure those equity positions remain firm and in place through the end of the year!
Also, in case you’re wondering, the average return over those 89 years in December is 1.4% – the second highest average return for any month of the year other than July.
But getting back to the idea of a random walk, which we know is a load of BS, there are more reasons for you to stay invested through the holidays and beyond.
One of the primary ones is momentum. Momentum is one of the last so-called “market anomalies” that is observable in the financial markets and is simply the idea that higher prices beget higher prices. Whether you realize it or not, the entire basis of trend following actually has its roots in momentum (and momentum, in turn, has its roots in behavioral psychology, but that’s a topic for another day).
The fact that we’re seeing such strong price momentum in the market actually shifts the likelihood of seeing higher prices ahead (in the near term) ever so slightly positive.
Then, of course, we have the notion that stock markets discount future economic activity, and as I’ve pointed out in previous articles, economic activity across the globe is improving, not deteriorating. So this too implies a stronger likelihood of higher prices ahead.
Altogether, it’s extremely difficult to make a case for being bearish throughout the end of the year. To do so would require you to bet on a lower probability outcome – something that could prove profitable every once in a while – but would be an extremely foolish move over the long run.
This is not to say that December is guaranteed to produce a positive return, or that some type of black swan event will not occur. As they say, historical performance is no indication of future returns. But history suggests that the final month (and the quarter) of the year are good times to have exposure to the stock market.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.
