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The Seasonality Timing System


The Seasonality System is a unique investment approach, grounded in three-quarters of a century of market testing, including 30 years of real-time performance. Its proven track record of superior reward vs. risk makes it particularly appealing for long-term investment portfolios, especially tax-deferred retirement accounts.

 

Overview

 

A New System

 

System Improvements

 

Leverage

 

Frequently Asked Questions:

 

          How do you implement the Seasonality System with Fosback's Fund Forecaster?

          Is this a short-term or long-term strategy?

          What are the costs of trading?

          How do taxes affect returns?

          Can you use the Seasonality System to buy and sell individual stocks?

          Why do seasonal patterns exist in the market?

          Do seasonal tendencies change?

 


Overview

Imagine an investment system that exposed you to the risk of market fluctuations less than a third of the time. All other things equal, you would certainly have more sleep-filled nights than if you were invested all of the time, as most people are – and as you may be right now. Less market exposure means less risk.

 And what if that same investment system just happened to produce the same or greater returns than a “buy-and-hold” always-in-the-market approach. Now, you’re having your cake and eating it, too.

Well, it can be done. The track record proves it. 

In March 2001, The New York Times reported that a timing system with precisely these characteristics “outperformed every other timing model monitored over two decades.” Times columnist Mark Hulbert particularly lauded the System for its “conservatism”; in other words, its ability to earn returns with significantly below-average risk. 

The investment system receiving The Times’ extraordinary accolade was created for The Institute for Econometric Research in the mid 1970s by Norman G. Fosback when he was President and Research Director of The Institute, one of the world’s leading stock market research and advisory organizations. (Note: The Institute and all of its popular investment publications were acquired by Time, Inc. in 1998, and were shortly thereafter discontinued.) 

Although several other analysts had also observed seasonal tendencies in the stock market (most notably Arthur Merrill, in his classic book, Behavior of Prices on Wall Street), no one had completely evaluated the historical evidence nor systemized the patterns into a practical investment approach. The Fosback approach initially involved applying state-of-the-art computer modeling techniques to evaluate nearly half a century of equity returns (from 1927 to 1975). The research identified the best times of the year to buy and sell stocks. Ultimately, the system was refined to about 16 to 18 short-term trades per year, involving patterns of particularly bullish markets around the ends of the month and before market holiday closings. 

Based on the success of the computer modeling, Fosback applied the system for The Institute to real-time trading in no-load mutual funds starting in 1977. In the early 1980s, he added to this portfolio management repertoire formal real-time portfolios of futures on various market indexes. The track records of all of these portfolios, which eventually reached nearly 50 in number (including mutual funds, and stock index futures), were published continuously and in real time over nearly a quarter of a century in The Institute’s investment advisory services, Market Logic and Mutual Fund Forecaster, both of which Mr. Fosback principally wrote and edited. Every portfolio made money, and the returns were astounding. The original mutual fund based system rose in value by 3,515% over the following 23 years, or 17% per annum compounded, and the first stock index futures-based portfolio soared 2,590% in 18 years.

In 1998, The Institute for Econometric Research was acquired by Time, Inc., Fosback stepped down as its President, and soon thereafter departed. But that was, as we shall see, and as Sir Winston Churchill so eloquently put it, merely the end of the beginning.

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Introducing . . . A New System

After he left The Institute, Fosback reevaluated the entire Seasonality System. Sure, it had worked well, and made lots of money for The Institute and its investment newsletter subscribers. But could it be better? 

Market seasonality theories had been around a long time. While the system Fosback developed for The Institute revolutionized market timing, as The Times article demonstrated, it was based on old data and old models. To find out how much better it could be Fosback started from scratch: New data, new computer algorithms, new timing indicators, new models . . . in short, new everything. 

The result of this new research is a new system – the Seasonality Timing System. 

In developing our new and revised system, the two original portfolio goals were retained: (1) superior return, and (2) below-average risk. How can any investing system hope to achieve both of these goals simultaneously in a market in which higher returns are generally achieved only by taking greater risks, and where risk is usually reduced only at the cost of earning lower returns? Here’s how: 

First, the Seasonality System identifies a handful of buy and sell points each month that are combined into a continuous trading program, alternating positions in equities – generally index mutual funds – and money market positions – usually money funds. In other words, portfolios are invested in the stock market during prospectively bullish periods and in the money market during periods expected to be neutral or bearish. 

Of course, only after the fact can we know for sure which periods in the market really were bullish, neutral, or bearish. But the Seasonality System gives us a keen insight into the probable answers – in advance. And that’s a good way to make money. 

Second, a big advantage of the System is that the bullish periods account for less than a third of all market trading days. This enables an investor to keep his or her investment in risk-free money market securities more than two-thirds of the time. That’s right – zero risk plus a money market return more than two-thirds of the time

The superior returns that the Seasonality System earns on the approximate one-third bullish market days (on the average) plus the risk-free interest earnings the balance of the time, are designed to produce returns that equal or beat the stock market as a whole and with less than a third of the equity exposure.

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What Are the System Improvements?

Now, how does the new system differ from the original: 

The first, and most important area of change, is a precise identification of the market sector whose returns contain the most significant seasonal properties: small stocks (and, even better, micro-cap stocks). In the “old” days the Seasonality System could be applied to just about any major sector of the U.S. market: large-caps, mid-cap, small-caps, growth stocks, and value stocks. That is why all of the dozens of mutual funds Mr. Fosback identified for trading in the 1970s, ‘80s, and ‘90s rewarded investors with profits. But now, things are different. 

The reason, confirmed by independent studies, is that seasonal patterns in equity prices are caused mainly by the trading activities of individual investors; institutional investors are far more passive in this regard, essentially just investing money anytime they get it and, to the extent they engage in market timing at all, buying high and sell low -- not a great recipe for beating the market. Individuals were once major direct investors throughout the stock market, so seasonal patterns were evident in every major market index. Now, however, the areas of the market overwhelmingly dominated by institutions – large-caps and mid-caps (both growth and value stocks in each) – have very little seasonal movement. Instead, the market area with the most intensive seasonal pattern is that in which individual investors play the greatest direct role, and that is the smaller stocks that are generally eschewed by institutions owing to below-average liquidity. 

Second, in addition to the traditional month-end and holiday-related seasonal patterns of the past, we have added a day-of-the-week factor.

Third, the new system adds several holiday-related periods in the last two months of the year.

Fourth, the last trading day of the calendar year, once one of the strongest, has been eliminated from equity investment in the Seasonality System.  

Finally, to further enhance return potential, we have introduced the use of leverage in this otherwise low-risk system, a concept that is discussed at length below. 

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Leverage

Leverage increases both return and risk. The Seasonality System puts a portfolio at risk in the stock market only one-third the time. Doubling that exposure with leverage would still produce less risk overall than if it were fully invested in stocks all of the time. And if the portfolio achieves its aim of generating good returns in the first place, the leverage makes the ultimate returns even better. 

You can leverage a market index investment in three basic ways: If trading index mutual funds, choose funds (there are many) whose portfolios are themselves leveraged. If trading exchange traded funds (ETFs), buy them on margin. If trading stock index futures, post a margin that is less than the face value of the futures contracts. (A fourth alternative is to trade index call options; however, the premiums of index options are generally so great that this is seldom a profitable trading medium.) 

When they employ leverage, the Seasonality System portfolios rise and fall much faster than the market during the times they are invested in equities. Let’s say the leverage is 2 to 1, equivalent to buying the market index equities on 50% margin. If the market rises 1% in a given day, the portfolio rises approximately 2%; if the market falls 1%, the portfolio declines about 2%. 

During the remaining two-thirds of the time, of course, the Seasonality System is risk free and earns money market interest. 

The goal with leverage: Significantly beat the market during seasonally favorable periods while incurring greater risk, but still keep overall risk below average owing to the extensive periods when the portfolios are kept in the risk-free money market.

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Frequently Asked Questions

 

How do you implement the Seasonality System with Fosback’s Fund Forecaster? 

In each issue, we identify upcoming periods of favorable market seasonality, pinpointing the exact day you buy and the precise day you sell. Specifically, to capitalize on the market’s seasonal tendencies, you should buy at or near the close of trading on the day immediately preceding the first seasonally favorable day, and you should sell at or near the close of trading on the last trading day of a favorable period. This technique will put you in the market precisely on the seasonally favorable trading days. 

We also tell you why each favorable period is bullish. Then, we recommend specific trading vehicles, such as index mutual funds and exchange-traded funds, featuring a variety of leveraged (or non-leveraged) options. 

Investors should note that when you buy and sell mutual funds, including switching from an equity fund to a money fund (and vice versa), all transactions are automatically executed at the close of a market day, and the orders can be placed anytime after the previous trading day’s close. 

In the case of exchange-traded funds, stock index futures, and all other continuously traded investment and speculative vehicles, buy and sell orders must be entered just before the close of trading on a given day to approximate execution at the market close. 

 

Is this a short-term or long-term strategy? 

The Seasonality System should be viewed as a long-term investment program. 

Yes, in a typical year, the System yields about 15 to 20 round-trip (buy-and-sell) trades, with positions in equities ranging in length from one to eight trading days. So from both a length-of-holding and frequency-of-trading standpoint it seems to be short term. 

Why then, should you think of it as long term? The answer, simply, is because the Seasonality System is based on market probabilities that produce a favorable reward-risk outcome over longer periods of time. 

Clearly, from hour to hour and from day to day many factors influence the returns of individual stocks and the market as a whole. Most of these factors are random and unpredictable; that is, they just hit the market out of the blue (which is why the market as a whole, and individual stocks, can jump sharply one day and plunge the next). Not surprisingly, both our historical simulations and real-time trading results show that approximately a third of the Seasonality System trades incur losses, and it is obviously impossible to know in advance which ones they will be. Fortunately, the typical loss is smaller in magnitude than losses incurred from strategies that hold security or market positions for long periods of time because the exposure to the market is relatively brief. Over time, however, all of those unpredictable random shocks in the market cancel out (some up, some down), and what is left is the systematic above-average returns of the seasonally favorable periods! 

 

What are the costs of trading? 

The high frequency of trading required by the System obviously makes it inappropriate in any investment that has high, or even above-average, trading costs. These costs can include brokerage commissions, sales loads and redemption fees, early redemption fees, bid-asked spreads, and any price movement caused by the supply and demand implicit in the trades themselves. 

However, proper selection of investment vehicles makes trading costs inconsequential and, in some cases, nonexistent. No-load mutual funds that do not impose redemption fees on short-term trades, stock index futures, and exchange-traded funds are all good choices because they can involve relatively low or even, in the case of the no-load funds, zero trading costs. These are the vehicles that we use and publish in the newsletter recommendations. 

 

How do taxes affect returns? 

Taxes are an important consideration in any investing system, especially one involving short-term trading. Simply minimizing taxes without regard to any other considerations is not prudent. But in the long run, every investment program must be evaluated in terms of its net aftertax return, not pretax. The Seasonality System deserves careful consideration in this regard owing to its complete reliance on short-term capital gains and interest income, both of which are taxed at ordinary income tax rates. Fortunately, there are solutions. 

To begin with, individuals in low and middle-tier marginal tax brackets may find that taxes are not a determining factor in their investing strategy. In the low brackets, long-term capital gains have only slightly preferential tax rates. Currently, investors in the 15% marginal tax bracket for ordinary income are taxed at a 10% rate on long-term gains, while investors in all higher brackets are taxed at 15% on long-term gains. However, individuals in high tax brackets, where ordinary income (including short-term gains) is taxed at a much higher rate than long-term gains, should consider whether the System’s investing style and reward/risk goal is compatible with their personal tax situation. 

Investors concerned about the taxability of their investments should consider two strategies. First, applying the System in any kind of tax-deferred account is ideal since all capital accumulation in those accounts is tax free in the year incurred regardless of the individual’s tax rate. Indeed, anyone who combines short-term trading with long-term investing should always consider applying the short-term in tax-deferred accounts and the long-term in regular accounts. 

Second, tax-conscious investors can consider using stock index futures as an alternative to no-load mutual funds. Futures provide a convenient trading alternative to mutual funds and offer a partial tax shelter: Capital gains and losses on futures are taxed 60% long-term and 40% short-term. For example, consider an investor in the top 35% marginal tax bracket who realizes a $100 gain on a trade: $60 of the gain is long term and taxed at 15% for a $9 tax, and $40 of the gain is short term and taxed at 35% for a $14 tax. Thus, the total tax on the $100 gain is $9 plus $14, or $23, producing an effective tax rate on futures of 23%. 

 

Can you use the Seasonality System to buy and sell individual stocks? 

Yes, although this is not the optimal application. Trading individual common stocks back and forth according to the System’s buy and sell signals must overcome two obstacles: First, trading costs (commissions and bid-asked spreads) can be substantial, even though online trading with discount brokers has dramatically reduced commission rates in recent years. 

Second, although the price trends of most stocks are correlated with the overall market to some degree, individual stocks also react to non-market forces, such as events that affect their companies or the industries in which they operate. The price patterns on which the Seasonality Timing System is based reside in the market as a whole, so it is best to apply the System to market-diversified portfolios. 

However, accurately identifying seasonal market patterns can create an edge for common stock investors because most stocks are correlated with the market to some degree. 

If a stock is contemplated for purchase, executing that purchase just before the start of a string of prospectively favorable trading days puts you in position to gain the benefit of the expected upside price advantage on those days. 

By the same token, a stock contemplated for liquidation with no immediate application of the proceeds should generally not be sold when a seasonally favorable period is about to begin; rather, it is optimally sold at the conclusion of the favorable market period. Not every such purchase and sale will produce extra profits, but over a long period of time, many such transactions turn the law of averages in your favor. 

 

Why do seasonal patterns exist in the market? 

A seasonal pattern is one that tends to repeat on a weekly, monthly, or quarterly basis, or otherwise tends to repeat from year to year. We have observed many seasonal patterns in the stock market, caused by a number of factors. Here are a few examples: 

First, the market tends to perform better around the end of the month. This may be related to the pattern of aggregate monetary inflows to the market from individuals’ monthly salary payments and from contributions to private pension plans that are immediately funneled to the market. 

Market patterns during the week trace to the tendency of individuals to sell stocks early in the week following a weekend of study of their portfolios, and to buy stocks at an increasing rate as the week progresses as they receive recommendations from brokers, advisors, friends, and media. 

A pattern of historically superior returns prior to market holidays and weekends may be caused by the unwillingness of short sellers to carry positions into periods of market closings and to their covering of positions just prior to those closings. In addition, buoyant investor psychology accompanies holiday periods. 

 

Do seasonal tendencies change? 

Yes. Seasonal market patterns do change over time simply because the market structure itself changes. Today, for example, institutional investors play a much greater role in the market and individuals correspondingly less, especially in large-cap stocks. Financial derivatives play a greater role than in the past. International markets are increasingly intertwined. Some types of retirement plans, such as IRAs and 401(k)s are relatively recent innovations. Demographics change, too, based on variable birth and death rates through time. 

As a result of these and other factors, money flows in and out of various sectors of the market can also systematically change. Finally, the mere existence of seasonal patterns, perceived or real, can prompt investors to alter their trading habits to get a jump on other investors. 

We monitor market patterns continuously to detect changes. It is challenging because market seasonality is a long-term propensity, and is not clearly evident every day. Security prices can seemingly deviate from normal patterns for months at a time simply because a myriad of other factors also influence individual stocks and the market. It is best, therefore, to react cautiously to apparent seasonal changes. In the continuing quest of optimum performance, we modify and continuously fine-tune the Seasonality System.

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