Trick or treat?

Trick or treat?
Commentary: Should you try to get a head start on the Halloween Indicator? [¹]

By Mark Hulbert, MarketWatch | 1 October 2007

ANNANDALE, Va. (MarketWatch)— It seems too good to be true.

Can market timers really improve on the famous seasonal pattern known as the Halloween Indicator, also known as "Sell in May and Go Away?," getting into the market before (or after) the official start of the pattern on Halloween and out of stocks before (or after) the official exit on May Day?

The odds of success would certainly not appear to be very high. After all, market timers in general have very poor success rates, rarely doing better over the long term than simply buying and holding. Why would we think that they can do any better timing their entries and exits in October and April than in any other month of the year?

Well, the proof of the pudding is in the eating.

And over the past five years, both market timing newsletters that I monitor that regularly second-guess the Halloween Indicator have significantly increased that seasonal pattern's performance.

Before proceeding much further, it's important to review this Indicator's statistical foundation. Perhaps the most comprehensive review of its historical legitimacy appeared in the December 2002 issue of the prestigious academic journal, American Economic Review. It was reported there that in 36 of 37 countries studied, average stock market returns from Halloween through May Day (the so-called "winter" months) were significantly higher than equity returns from May Day through Halloween (the "summer months"). (Read academic study.)

In fact, the study found, the summer months' returns have averaged so much less than those of the winter months that almost all of the stock market's long-term returns have been produced during the winter months. That implies that simply going to cash between May Day and Halloween will have only minor impact on long-term returns while dramatically reducing risk— a winning combination that would show up in a much improved risk-adjusted performance.

The Halloween Indicator is thus in the rarefied ranks of those select few market timing systems that truly appear to work. But, not willing to leave well enough alone, two newsletters have for a number of years tried to second guess the exact days on which a follower of this seasonal pattern would enter and exit the market.

The first is the Almanac Investor Newsletter, edited by Jeffrey Hirsch, and the other is Sy Harding's Street Smart Report, edited by Sy Harding.

Both pursue surprisingly similar modifications to this basic seasonal pattern: Each relies on a technical indicator known as MACD to pinpoint the precise day on which they should get back into the market at the beginning of the six-month seasonal period, as well as when to get out at the end of that period.

MACD, of course, stands for moving average convergence divergence. It is a short-term momentum indicator, created several decades ago by Gerald Appel, editor of the Systems & Forecasts newsletter. It compares the relative movements of several moving averages of different lengths.

Sometimes these two newsletters' modifications are quite minor. In 2004, for example, the Almanac Investor Newsletter's version of this seasonal pattern for the S&P 500 index re-entered the market on Oct. 28, just three days before it otherwise would.

But in other years the differences have been quite significant. Last year, for example, Hirsch's re-entry for the S&P 500 didn't occur until Dec. 15, a month and a half later than otherwise.

The Hulbert Financial Digest has data for both newsletters' modifications of the Halloween Indicator back to mid-2002, more than five years ago. The HFD calculates their returns on the assumption that, when they are invested in stocks, they earn the return of the Dow Jones Wilshire 5000 Index; otherwise they are assumed to be invested in 90-day Treasury bills.

To put these newsletters' success into context, consider that since mid-2002, a buy-and-hold has produced a 9.4% annualized return. A purely mechanical application of the Halloween Indicator (automatically entering the market on Halloween and exiting on May Day) would have produced a 7.0% annualized return. This 7.0% return actually beats the market on a risk-adjusted basis, however, because it was produced with such low risk; it was out of the market 50% of the time, after all.

Now consider the performance of Hirsch's modification of the Halloween Indicator: It produced a 9.2% return (annualized) over the same period, or 2.2 percentage points per year more than a purely mechanical application of this seasonal pattern. This is only modestly behind a buy-and-hold return in terms of raw, unadjusted returns, and well ahead on a risk-adjusted basis.

Harding's system did even better, producing a 10.6% annualized return. That's 3.6 percentage points per year better than the mechanical version of the Halloween Indicator and percentage points per year ahead of buying and holding. And because Harding's system also incurs very low risk, its risk-adjusted performance is well ahead of the market itself.

What about this coming October? To be informed when these two newsletters actually trigger their buy signals, of course, you will need to subscribe to their services.

But one way in which their MACD-based systems are likely to trigger a buy signal (but not the only way) is if the market trends downward for a week or two and then quickly shoots upwards. [[WARNING: Sy does not reveal the time periods for his proprietary MACD calculations, so you can't just use the commonly published MACD and expect to get the same results.: normxxx]]

If that happens, it's more than likely not just a trick; but very much a treat.

Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.

Normxxx    
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