RMH Market Watch – "The October Effect"
The "October Effect" is the psychological perception that the stock market will be volatile and decline in this month. While not every October experiences turbulence, several factors contribute to this perception:
Historical Events: The most famous stock market crash in history, the Great Crash of 1929, occurred in October. This event led to the Great Depression and has left a lasting impression on market participants. Other significant crashes, such as the Black Monday crash of October 19, 1987, have also contributed to the perception of October as a volatile month.
Quarterly Earnings Reports: October marks the beginning of earnings season for many companies. As I mentioned in a previous response, earnings releases can lead to stock market volatility as investors react to the latest financial data and guidance.
Market Psychology: The historical perception of October as a volatile month can create a self-fulfilling prophecy. Traders and investors may become more cautious or nervous in October, potentially leading to heightened trading activity and price swings.
Portfolio Adjustments: Institutional investors and fund managers often engage in portfolio rebalancing toward the end of the year, which may involve selling or buying large quantities of assets. These actions can impact market prices and contribute to volatility.
Seasonal Trends: Some investors believe in seasonal patterns, such as the "October Effect" or "Halloween Effect," which suggest that stock markets tend to be weaker or more volatile in October. While these patterns are not reliable, they can influence trading decisions for some.
It's important to note that while October has experienced historical volatility, the stock market's behavior is influenced by a complex interplay of factors. Not every October will necessarily be volatile, and investors should base their decisions on a broader analysis of economic fundamentals, company performance, longer time horizons, and global events rather than relying solely on historical patterns or perceptions.
S&P 500 October 2022
S&P 500 October 2021
From comparing the S&P 500's October 2021 and 2022, you can see that they both end up net positive, but that 2022 was more volatile than 2021.
Why are earnings seasons so volatile?
Earnings seasons occur 4 times a year and while not every earnings season is volatile, it is important to understand the drivers of possible earnings volatility. Let's take a deeper look on why the release of quarterly earnings can cause market volatility.
Information Uncertainty: Earnings reports provide a fresh batch of financial information about a company's performance, including revenues, earnings, and future guidance. Investors react to this new data, and uncertainty can lead to rapid price swings as they process the information and adjust their positions.
Market Expectations: Prior to earnings releases, investors and analysts form expectations about a company's performance. If actual results fall short of these expectations, it can lead to disappointment and sell-offs. Conversely, beating expectations can result in a surge in stock prices.
Guidance and Outlook: In addition to the earnings numbers themselves, guidance provided by company management about future prospects carries significant weight. Optimistic guidance can boost confidence and stock prices, while pessimistic guidance can lead to declines.
Herding Behavior: Earnings reports often trigger herd behavior, where investors follow the actions of others, exacerbating price movements. Positive earnings can lead to a buying frenzy, while negative surprises can prompt mass selling.
Algorithmic Trading: High-frequency trading algorithms are designed to react quickly to earnings news, amplifying price swings as they execute trades in milliseconds based on predefined criteria.
Sector and Industry Trends: Earnings reports can impact entire sectors or industries. Positive results from one company may boost competitors' stocks, while poor results in a sector can lead to sector-wide declines.
Market Sentiment: Earnings season can influence overall market sentiment. A string of positive reports may boost confidence and drive broader market gains, while a series of disappointments can erode sentiment and trigger broader market declines.
Heightened information flow and investor reaction during earnings seasons, make them periods when stock prices can experience increased volatility as market participants adjust their portfolios based on the latest corporate financial results and guidance.
Volatility is driven by a multitude of factors and one way to analyze it is to use the CBOE Volatility Index, better known as the VIX. Below is a chart of the VIX in 2023 through mid-September. It started with a bit of choppiness in January and then really picked up in March due to the collapse of Silicon Valley Bank.
Through the summer, the VIX has been lower which is also a bit of a historical phenomenon and not unexpected due to lower trading volumes in the summer. Finance execs take vacation time off and leave their trading desks conservative instructions, end of year tax loss harvesting or portfolio rebalancing hasn't started up yet, and traders leave their computer screens to enjoy the last bit of good weather. And note for those aforementioned factors, we are referring to the large institutional companies that manage large amounts of assets and have market moving power.
Our Thoughts for this October
Historical phenomena are always an interesting case study and provide important context for investors to understand the broad factors that may be impacting their portfolio. Past trends do not usually show consistent, historical persistence and should not be the sole decision making criteria for an investment choice. After all, the future is not the past.
We at RMH are innately optimistic, however with a potential government shutdown looming, labor strikes, and the resumption of student loan payments, we will not be surprised if October is a volatile month in the stock market. We do not believe anything this next month will materially impact investor's long-term strategies, but it may be a month where checking on your portfolio daily causes more stress than necessary. Instead, get outside and enjoy the fall weather and remember that disciplined investment strategies held over years will prevail over short-term worries.
If there are ever any topics you wish for us to explore, please let us know. We are here to help and guide you through these times.
We thank you all for taking the time and reading “Market Watch.” It is meant as an educational piece on the always evolving markets. It is something we plan on providing every month, and your feedback is very important to us.
On a personal note, RMH is now in the position to bring on new clients so please be sure to share this informational letter with whomever you wish. RMH’s focus is on the customizable investment needs of individuals, families, and foundations. We enjoy working with our clients to better understand their goals, values, and passions for what is important in their lives. In expanding our client base, we look forward to working with people who share these same desires.
This edition of Market Watch was written by RMH Analyst, Ashlyn Tucker, under the guidance of Richard Mundinger, CFA.