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Make 34% from 4 phone calls

Created:

8 July 2005

Would you like to know which sectors will be the top performers this summer, and which will be the worst? And then which will be the top performers in the fourth quarter, and in the first and second quarters of next year? Of course you would. If you did, you could make just four phone calls to your broker each year - and then sit back while you make market-beating returns.

Well, there is now evidence that this kind of 'seasonal investing' can be made to work. It might sound about as scientific as the old adage: "Sell in May and go away, buy back on St Leger's day". But stock-market performance in the last 20 years supports the theory that some sectors do an awful lot better than others at certain times of the year. In fact, armed with this information, you could have made average returns of 34 per cent a year since 1985 - simply by rotating your portfolio into the best-performing sector, based on the historical evidence, of each quarter.

Seasonal investing can pay

"Sell in May..." is one of the City's oldest trading strategies. It dates back to the 18th century when, in 1776, Lieutenant-General Anthony St Leger founded a two-mile flat race at Doncaster. Still run today, the race falls in the middle of September and is said to mark the end of the stock market's dog days of summer. And even today, the strategy works. Between 1985 and the end of 2004, an investment in the FTSE All-Share that was held throughout the period would have quadrupled. If, however, you'd skipped the period between June and October - in keeping with the old adage - your investment would have grown by five times. In other words, by following the adage, you would have improved your returns by a whopping 29 per cent.

That's because the best periods for stock market returns in the last 20 years have, on average, been the fourth and first quarters of each year: the fourth quarter has returned an average of 3.6 per cent and the first quarter an average of 3.7 per cent. Taking the two together, the phenomenon has been pretty consistent: the stock market rose between October and March in 15 out of the past 20 years - or 75 per cent of the time.

However, the evidence for worse performance over the summer months is a little patchy. Yes, the third quarter has been the worst-performing quarter in the past 20 years: the market has fallen in the third quarter in eight of the past 20 years and it's the only quarter in which the average return has been negative. But that still leaves 12 years - the majority - in which the market rose during the third quarter. Last year, for example, the third quarter was the best-performing period of the year - and this has been true on four other occasions since 1985. So it may be a case of buy on St Leger's day, but don't necessarily sell in May.

Holidaying brokers and sad investors

There are various theories on why the market follows a seasonal pattern, ranging from summer holidays to seasonal affective disorder (SAD). It's certainly true that markets are usually quieter during the summer, as investors take their holidays. Even the Australian market is quiet between July and September - winter in the southern hemisphere - although this may be because Australian traders follow the lead of the more dominant northern financial markets.

Another possible explanation for the weak third quarter is the SAD effect. When the days start to shorten after the summer solstice, this has a negative psychological effect on some people. And if those people are investors, they become more cautious, or so the theory goes. As Ian Garrett, professor of accounting and finance at the University of Manchester, says: "If you suffer from the winter blues, you become more risk-averse." And although only a minority of the population suffer from SAD, studies do show that it has an impact on investor behaviour around the world.

Why, then, does the market rally in the fourth quarter when the nights are really drawing in? One factor is certainly Christmas, when the biggest consumer spending boom of the year leads to a high level of economic activity. Then, in the first quarter, there is often a rally on the back of an influx of money from pension funds and bonus schemes at the start of the year.

But the factor that arguably has the biggest cyclical impact is analyst earnings revisions. Analysts are eternal optimists who almost invariably forecast that a company will grow its earnings over time. What this means is that, towards the end of the year, when analysts and investors start valuing a company on its next year's earnings - which almost always assume growth - the rating looks cheap.

Come May, however, that growth can often start to look a little shaky. So analysts trim their earnings estimates. Investors, in turn, become more cautious on growth prospects and turn to more defensive sectors over the summer.

Defensives while on holiday, cyclicals on New Year's Day

This seasonality also has an effect at sector level. During the summer, there is a clear pattern of outperformance by defensive sectors such as beverages, tobacco, pharmaceuticals and utilities. In the second quarter, beverages and personal care have served up a 5.7 per cent average quarterly return over the last 20 years, and tobacco 5.5 per cent. And in the third quarter, the best-performing sector over the period has been utilities, which has risen by an average of 2.7 per cent in each period. It is closely followed by the pharmaceuticals and tobacco sectors, which both averaged 2.4 per cent quarterly growth over the period. All of these sectors beat the FTSE All-Share which has, on average, dropped 0.8 per cent during the third quarter over the past 20 years.

Conversely, the worst places for your money during the summer months are cyclical or growth sectors - such as electronic and electrical equipment, leisure, telecoms and software. During the second quarter, the weakest sector is the telecom sector, which has, on average, dropped by 1.6 per cent in that quarter. In comparison, the FTSE All-Share has produced an average positive return of 1.9 per cent in that quarter over the period. And the worst-performing sector in the third quarter has been electronic and electrical equipment, which has fallen by an average of 6 per cent during that quarter.

But while it usually pays to be defensive during the summer, don't stick with defensive sectors into the winter. You could end up nursing losses. Defensives perform badly in the first quarter - the worst-performing sector is food and drug retailers, which returned an average of only 1 per cent in that quarter over the last 20 years, against the FTSE All-Share's 3.7 per cent. Other defensives, including the utilities, personal care and food producer sectors, also did poorly.

Make 34 per cent a year - the easy way

So, while the St Leger Day strategy is simple and relatively reliable, you stand to make far more with a sector approach. And even with the sector rotation approach, there are no sums involved. In fact, in the last 20 years, all you would have needed a calculator for is calculating your impressive returns.

You would only have had to make four investment calls - or phone calls - to invest in:

- First quarter: Household goods

- Second quarter: Forestry

- Third quarter: Utilities

- Fourth quarter: Electronic and electrical equipment.

By simply rotating into these sectors each quarter since 1985, you would have turned £1,000 into £248,809 - equivalent to a staggering average annual return of 34 per cent.

By contrast, had you switched into the worst-performing sectors each quarter - food and drug retailers, telecoms, electronic and electrical equipment and household goods, respectively - you would have reduced your £1,000 to a measly £26.

The health warning

Before you get too carried away, though, bear in mind the potential drawbacks. As Richard Batty, Global Investment Strategist at Standard Life, says of seasonal investing: "It looks good on paper but, in reality, it is much harder to achieve." And disappointingly, it looks as though seasonal investing has become a bit more hit and miss of late. Mr Batty points out that an investor who followed the strategy from the 1970s into the late 1990s would have done well, but would then have come unstuck had he or she continued into 2000.

It seems that during times of weaker market conditions, seasonal investing becomes less reliable. As Mr Batty says: "There is higher volatility when the market is trendless." This means that the market lacks direction - sectoral shifts tend to be more short term and can go against normal seasonal patterns.

This year, for example, the cyclical sectors, such as mining, did well during the first quarter - as would be expected - but ran out of steam in February on growth concerns. Then, following some good news relating to Chinese demand, investors recently swung back behind the mining sector again. This goes against the normal seasonal trend, which would favour defensives at this point.

What to buy now

But if you're not too phased by this health warning, now is the time to get into position for the fourth quarter market revival. After all, St Leger's Day is just a couple of months away and, historically, the fourth quarter is still one of the best for stock market performance.

As we've shown, the best-performing sector between the start of October and the end of December has been electronic and electrical equipment, returning a whopping 10.4 per cent on average, over the last 20 years. Next best have been telecoms with 8.6 per cent and information technology with 7.4 per cent.

However, while electronic and electrical equipment has given excellent average returns, it has been a volatile sector. In fact, electronic and electrical equipment actually lost ground during the fourth quarter in half of those 20 years.

More reliable returns were seen in the telecoms sector, which made a positive return 75 per cent of the time. So, to make a seasonal investment this September, we would suggest buying BT. It's the second largest telecom stock, capitalised at £19bn, so it should provide good exposure to the sector's seasonal swing. And even if the sector fails to deliver the goods this year, at least BT gives you the prospect of a solid dividend yield.

Alternatively, if you decide to go with the volatile electronic and electrical equipment sector, Renishaw is probably your best bet - although it is already highly rated. Or, to invest in the information technology sector, Sage is a sensible pick, being the largest stock by market capitalisation.

THREE SEASONAL SECTOR TRADING STRATEGIES

Utilities: Buy in June, Sell in October

The utilities sector has historically been the best-performing sector during the third quarter, but has underperformed the All-Share during the fourth quarter - and is one of the worst sectors during the first quarter. So to beat the market, buy utilities in June and sell in October. National Grid Transco (NGT) is the largest listed utility company and represents a reasonable proxy for the sector. NGT is also a relatively safe play - its regulated nature makes it dull but defensive, with reliable dividend income. Scottish & Southern could be another one to consider. It is large, liquid and recently reported forecast-busting results, accompanied by a commitment to deliver at least 4 per cent real dividend growth over the next three years.

Household goods: Buy in December, Sell in April

Household goods has been the place to be during the first quarter. But, after March, the sector begins to underperform and, in the fourth quarter, household goods has historically been the worst performer. So get in at the end of December, and make your escape in April. Headlam, the UK's leading floorcoverings supplier, is the pick of the bunch. As the largest stock in the sector, it should reflect sector trends. It is also a good investment story in its own right - net cash on the balance sheet and the 4 per cent dividend yield provide security.

Construction & building materials: Buy in December, Sell in April

Like the household goods sector, construction and building materials has a good track record during the first quarter, but it underperforms the market in all other quarters. We have discussed this seasonal effect before in relation to the housebuilders, using it to devise a successful trading strategy (see IC, 12 November 2004). Wolseley is the largest construction and building materials stock by market capitalisation and, with its exposure to a range of construction markets, makes a good bellwether. Of the housebuilders, Barratt is one of the largest and most reliable, recently announcing its 13th consecutive year of record profits.

HOW TO TRADE SECTORS

Sectors can be traded either through a sector-specific fund or by using a stock as a proxy for the sector. Certain sectors such as pharma, technology and telecoms are well-served by fund providers, although it may be difficult to find a fund for other, smaller sectors.

Barclays Global Investors used to offer UK sector-based exchange traded funds (ETFs) but had to close them because demand was not high enough. One attraction of these products was their low management fees. Barclays Global Investors still offers a wide range of US sector ETFs, though.

If you choose to use one stock as a proxy for the sector, choose carefully and go for stocks that offer good liquidity. We suggest possible stock-picks in the trading strategies box (see left).

RISKS OF SEASONAL TRADING STRATEGIES

- The seasonal pattern can vary year to year - and in some years is entirely absent.

- Macroeconomic factors can wipe out seasonal trends and are hard to predict.

- Transaction costs and stamp duty eat into returns.

- Illiquidity during the slower months can widen the bid-offer spread, making selling prices lower and therefore reducing returns.

- There is a risk that the stocks chosen as a proxy for sectors do not move with their sectors due to company-specific factors.

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