The Cold Truth About Summer Rallies

Summer has a sunny reputation on Wall Street, with “summer rally” having a comfortable and familiar ring associated with backyard barbecues and lounging by the swimming pool.

Last August’s slump in major indexes was, of course, an exception, maybe proving the rule--the summer of 1998 was by far the worst in the last 15 years. (See accompanying chart.)

But there isn’t much evidence that stocks are hot when the temperatures rise. “It’s market folklore that there’s a summer rally,” said Clay Singleton, a vice president at researcher Ibbotson Associates in Chicago. “Rallies don’t happen frequently enough in summer to make for a reliable trading system.”

Indeed, depending on whom you talk to and how many years you examine, the summer months rate somewhere between so-so and mildly bullish.

Over the last 15 summers, for example, the Dow Jones industrial average has risen 11 times, excluding the effects of dividends. That’s not bad, but the market has risen in 13 of those years.

Besides, the Dow has declined in two of the last three summers. Last year’s summer swoon of 16.2% was the worst in a generation.

Those results measure the stock market’s performance between Memorial Day and Labor Day, which is how Wall Street defines summer.

“The rules are extraordinarily loose and self-serving,” said Philip Orlando, chief investment officer at Value Line Asset Management in New York.

But even if you examine the market’s performance based on the calendar summer--from June 21 through Sept. 22--the results aren’t different. Using this measure, the Dow also gained ground in 11 of the last 15 years and slumped four times.

So if summer rallies appear to be over-hyped, how did this folklore start?

Perhaps some of it has to do with people feeling good while on vacation. Or perhaps investors tend to extrapolate long-term trends from a few coincidences. For example, the market did enjoy six straight summer rallies from 1984 through 1989. “People have a need for order and structure, so they tend to see patterns even if they’re not there,” Singleton said.

Orlando thinks the summer months enjoy a tail wind from overly optimistic earnings forecasts that characterize the year’s early and middle months. Only by autumn do professional stock analysts begin to deflate their profit projections to match reality, he said. “September and October are when the chickens come home to roost.”

Historically, September and October have been the market’s two weakest months. Yet a few observers believe the real culprit is summer.

Bear markets “begin either in the January-February or July-August periods,” said David Menashe, editor and publisher of Fundline, a newsletter in Woodland Hills. “I’m not looking for a rally this year.”

Still, it would be a stretch to characterize summers as unprofitable periods because stock prices do tend to rise. But the rallies in recent years have been less dramatic than they’ve been other times of the year.

So you probably shouldn’t rearrange your portfolio just because temperatures are rising.

“If you’re investing for retirement 20 years down the road, there’s not much point in messing around with your portfolio now to reflect what might happen in summer,” said Mark Riepe, a Charles Schwab vice president who heads the company’s Center for Investment Research.

Riepe examined quarterly stock market returns dating to 1926, using the Standard & Poor’s 500 index rather than the Dow. The range of quarterly results was fairly tight, he said, suggesting that there’s little reason to exploit seasonal factors.

The April-June quarter, which mostly encompasses spring, has been the strongest historically, producing an average gain of 3.68%, according to Riepe. Conversely, the first-quarter months of January, February and March were weakest, yet even they generated an average gain of 2.84%. While interesting, he noted it wasn’t a statistically important difference.

In fact, scholars have searched far and wide for seasonal cycles and other anomalies that could be exploited for easy profits in the stock market. They haven’t found many, and summer isn’t one of them.

The strongest seasonal pattern is the tendency for stock prices to rally toward year-end and into the first week or two of January. Known as the “January effect,” this pattern tends to occur after weakness from October to December.

Thinly traded stocks are typically the ones for which the January effect works best.

Fourth-quarter tax selling by individuals is the catalyst cited for putting the January effect in motion. But many mutual fund managers also play a role by weeding out losers before Oct. 31, the common year-end date for the industry.

“Fund managers often realize tax losses on certain stocks to minimize the capital gains that they must distribute to investors,” Orlando said.

Curiously, a January effect also can be seen in other nations, including those with significantly different tax laws. “Maybe that, too, is driven by selling from U.S. investors,” Singleton said.

But even the January effect doesn’t occur regularly. “It hasn’t been as strong over the past couple of years as previously,” Singleton said.

Thus, like many short-term trading approaches, the benefits of seasonal market timing are questionable--especially when you factor transaction costs and taxes into the equation.

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Summer Rallies: Hot or Hype?

Summer puts many people in a good mood, but there’s not much evidence for a seasonal market rally. Below, the performance of the Dow Jones industrial average, excluding dividends, from Memorial Day to Labor Day, the traditional dates by which Wall Street measures summer. For the full year, the Dow rose in 13 of these 15 years.

1984: 10.6%

1985: 2.5%

1986: 4.1%

1987: 14.2%

1988: 5.0%

1989: 10.4%

1990: -7.3%

1991: 4.5%

1992: -3.1%

1993: 3.0%

1994: 3.4%

1995: 6.4%

1996: -2.6%

1997: 3.8%

1998: Summer, -16.2

Source: Dow Jones & Co.

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Russ Wiles is a regular contributor to The Times and coauthor of “How Mutual Funds Work,” published by Simon & Schuster. He can be reached at russ.wiles@pni.com.