The Halloween Effect – True or False?

It has been a market bromide for decades: “Sell in May and go away.” This piece of market wisdom is sometimes referred to as the Halloween Effect, a strategy for going long on stocks on October 31 and selling the positions on May 1 for a gain. It assumes that, with few exceptions, the November through April period will be more bullish than the May through October period. But is it true?

The Halloween Effect

Actually, it is true. One study done in 1999 extensively reviewed stock market prices in all the world's major markets, and even many minor markets (e.g., Denmark) going back many years. At least since 1970, the data shows that the Nov/Apr period significantly outperforms the May/Oct period in 36 of 37 markets studied. The Halloween Effect is much stronger in some markets than others, and is particularly strong in Europe. The effect is extremely pronounced in the U.K., with evidence for its existence going back to 1694! It is also clearly present in the United States markets, if not quite so strongly. Sven Bouman and Ben Jacobsen, The Halloween Indicator, ‘Sell in May and Go Away’: Another Puzzle (1999).

The figure below, taken from that study, shows the respective returns for the Nov/Apr and May/Oct periods from 1970 through 1998 for many country stock markets, including the United States:

That's pretty compelling evidence! While a particular year may represent an exception, such as 1987 in which a U.S. market crash occurred, the stock market almost always does better in the Nov/Apr half of the year. The study's authors looked at many possible causal factors, such as interest rate fluctuation, people taking summer vacations May/Oct, whether the effect is sector-specific (it isn't), variations in trading volume, seasonal news and the like. None of them remotely accounts for the effect.

While the data is unequivocal and clearly establishes the effect's existence worldwide, what we don't know is WHY it happens; just that it does. And it happens consistently even though it is well known and expected, meaning that arbitrage and trading patterns taking the Halloween Effect into account have not canceled or really even modified it, as one would expect.

Theoretically, the effect's existence is implausible, all the more since no one can ascribe a reason to it. Efficient market theory in particular would predict that the effect actually is impossible. Don't laugh; a scientist once “proved” mathematically that bumblebees cannot fly. Put differently, the chance of finding a Halloween Effect for the Nov/Apr six-month period compared to the May/Oct period is 50%; even odds. But a 50/50 coin-flipping outcome is not what happens in the real world – the effect's consistency and continuity is overwhelming. So much for the random walk theory…

Newsletter author Mark Hulbert recently did his own analysis of the Halloween Effect since 1896 and found that it was not really found in the 1896-1951 period (the above study did not address the effect's existence in the U.S. prior to 1970), though it has been pronounced since. Hulbert suggests that no one can explain why it was present since 1951 but not before that. And right he is. But this is hardly surprising, since no one can explain the effect at all. Yet it occurs in virtually every major and minor market; even in the Southern Hemisphere, where the seasons are reversed and Christmas occurs during their summer time.

Old data, you say?

Check out this chart, courtesy of Benjamin Bohr from BetweentheNumbers.net:

This chart shows two things: 1) Hulbert was right about the Halloween effect not being seen prior to 1951, and 2) the effect is pretty reliable. For some reason, Februaries are weak and Septembers the worst.

What Does the Halloween Effect Mean for Traders?

The Halloween effect does not posit that on average the market will be strong NOV-APR and weak during MAY-OCT. We are talking relative strength here, not absolute. If a period is part of a bull market they may all be good; and vice versa. What the data tells us is that, year in and year out, corrections will tend more to happen MAY—OCT and rallies NOV—APR, on average.

The old saw says to sell in May and go away—but it doesn’t tell you when to buy. Being a contrarian, this tells me that September is (on average) the time to buy stocks or to buy OTM calls to speculate on stock movement. Or view late April/early May as the time to short the market or speculate by purchasing puts. These strategies assume, of course, that the stock itself conforms to the Halloween effect; not all of them do. You sort of want to check this over a 5- or 10-year stock for the chart, comprendez-vous?

If I am writing covered calls, they will do better November—April in general, and OTM call writes in particular will do better then. During the under-performing summer doldrums, stick to great companies outperforming the sucky market at the time, and write ATM calls (highest non-called return of all) or ITM calls, if you are more conservative.

But while putting our faith in the Halloween Effect, let's keep our powder dry. If the market goes into a correction, keep your covered call money in your pocket while looking for great bear call spreads – option trades in which the trader sells a lower-strike call and buys a higher-strike call, generating a credit.

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