Seasonality! A Highly Rewarding Investment Strategy Using Equities And Bonds

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Includes: IEF, SPY
by: Jeroen Blokland

Summary

The Sell in May effect in equities is well documented. During the 'winter' months stock markets perform much better than during the summer months.

But the returns on government bonds also reveal a strong seasonal pattern. One that is exactly the opposite to that of equities.

The combination of opposite seasonal patterns in equities and bonds translated into a very rewarding investment strategy. One that outperforms both in terms of return and risk.

This article is not about some flashy, new, investment strategy that 'promises' you returns you have never seen before (probably because they don't exist). No, quite the opposite. It shows that one of the 'golden oldies' of investment strategies still earned you a pretty impressive return in recent years. It shows that you can significantly enhance your return by just switching between equities and bonds twice a year. How easy is that!

Sell in May

Seasonality in equity markets has been well documented. Sell in May and the Halloween effect are well-known nicknames for the investment strategy where you sell your equities during the 'summer months' (May - Oct) and come back to the market when 'winter' arrives (Nov - Apr). But the fact that equities are not the only asset class that is characterized by a seasonal return pattern in much less talked about. And yet it's the combination of these seasonal patterns that provide a rewarding investment strategy.

The graph below shows the average calendar month returns on the S&P 500 Total Return Index (NYSEARCA:SPY) over the last two decades. As can be derived, investing in equities during the summer months doesn't get you all that far. The period from November to April yields much better results. The graph also suggests that calendar month returns are not constant over time. January, by many perceived as one of the best month for equities, has actually been one of the weakest, while May was much friendlier to equity investors than it used to be.

But when I calculate the traditional Sell in May/Halloween returns it becomes clear that the seasonality in equity markets is as alive as ever. During the period November - April the average return on the S&P 500 has equaled 8.5%, against a much lower return of 2.4% in the period May - October. The difference, 6.1%, looks pretty convincing.

Bond seasonality

But we already knew that one right? Let's take a look at Treasury bonds, instead. Below are the calendar month returns for Treasury bonds with a maturity between 7-10 years (NYSEARCA:IEF). Interestingly (or perhaps not), the best period to invest in bonds is completely the opposite to that of equities.

Well, that's not entirely true. The best period to invest in US Treasuries is actually between June and November (not May and October). Seasonality has 'moved' one month. During this period the return has averaged 5.0%, against just 1.9% between December and May. The result is a seasonal return difference of more than 3%. In bond investing that is pretty impressive. To add, the difference in returns between the traditional summer (May - Oct) and winter (Nov- Apr) equals 2.7%, pretty comparable to the 3% mentioned above.

Switching Strategy

The most interesting conclusion that follows from the charts above is, of course, that, in summer, bonds also outperform equities on an absolute basis. This enables a suitable investment strategy. The chart below tells why. It shows the average relative return of equities versus bonds per calendar month. The results are convincing. In summer months bonds beat equities almost every month, while in winter equities are the clear winners. Hence, there exists a clear seasonal effect in relative returns as well.

This seasonal return effect is pretty impressive, as the next graph shows. During the November - April period the S&P 500 index beats US Treasuries by an average of 6.6%. But in summer you are much better off with bonds as they yield a 2% higher return. The difference is a massive 8.7%, on average each 12 months.

I will show one last chart that makes the profitability of this investment strategy even more tangible. Suppose that, since 1995, you invested in equities during winter only, before completely switching your portfolio to bonds during summer. This strategy would have outperformed a buy and hold equity investment by a neat 500% and a buy and hold bond portfolio by 770%. Moreover, the overall risk of the seasonal switching strategy is lower than that of equities. The Sharpe ratio (the average return divided by the standard deviation of that return) is almost twice as high.

In addition, this strategy is very easily implemented since it involves general indices that are covered by many investment funds. Also, this strategy should be pretty cost efficient as it only requires a switch twice a year. So, while not so flashy or resourceful as many other investment strategies that are out there, seasonality is at least one that works.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.