September Effect

September has historically shown to be the weakest month for equities, with data stretching back over a century.

The S&P 500, a broad market index, has averaged a decline of 1% in September since 1928, making it the only month with a negative average return.

This pattern, often referred to as the “September Effect,” has persisted across various markets and economic cycles.

Key Takeaways – September Effect

• Historical Weakness
  • September has consistently been the weakest month for equities.
  • The S&P 500 has averaged a 1% decline since 1928 in September.
• Institutional Rebalancing
  • Large traders/investors (especially pension funds) often reduce equity exposure and shift to safer assets in late September.
• Psychological Factors
  • Post-summer sentiment shifts and tax-loss harvesting contribute to cautious market behavior.
• Not Guaranteed
  • While statistically significant, the September Effect isn’t an automatic trading opportunity due to market efficiency and yearly variations.
  • Things that are known generally get arbed out of markets, including matters like the January Effect and September Effect.
  • Understanding market mechanics and motivations of the various players in markets is the broader take-home lesson for such seasonal patterns.

Statistical Significance

The September Effect been found through statistical analysis.

Studies have shown that the underperformance in September is statistically significant, even when controlling for other factors such as macroeconomic conditions and geopolitical events (i.e., in order to better isolate whether other factors are at play).

This persistence suggests that there are underlying structural or behavioral factors going on rather than coincidence.

Institutional Factors

Quarterly Portfolio Rebalancing

A major contributor to September’s weak performance is the practice of portfolio rebalancing by institutional investors.

These large players, including mutual funds, pension funds, and endowments, typically adjust their portfolios at the end of each quarter.

The last half of September, coinciding with the end of the third quarter, sees an increase in trading activity as these institutions realign their holdings to match their target allocations.

Pension Fund Dynamics

Pension funds, in particular, are important in this rebalancing effect.

For example, data from the Milliman Top 100 Pension Funding Index shows the level of funding in pension funds (with 100% representing full funding, >100% showing more than full funding, and <100% showing less than full funding).

This funding status influences their trading strategies – e.g., often leading to a reduction in equity exposure to lock in gains and mitigate risk.

Risk Reduction and Liability Immunization

With strong funding levels, pension funds are increasingly focused on liability-driven investing (LDI) strategies.

This approach involves reducing equity risk and immunizing liabilities against interest rate fluctuations.

The shift toward investment-grade credit instruments in September is a common manifestation of this strategy.

These assets offer a better match for pension liabilities while providing more stability than equities.

Behavioral and Psychological Factors

Post-Summer Sentiment Shift

September marks the end of summer in the Northern Hemisphere (where most of the world’s economic activity is), coinciding with a shift in investor sentiment.

The return from summer vacations often brings a reassessment of markets and economic realities.

This psychological reset can lead to increased caution and a tendency to reduce risk exposure.

This is most relevant to discretionary traders.

Tax-Loss Harvesting

For those with taxable accounts, September presents an opportunity for tax-loss harvesting before the year-end rush.

(This is what’s commonly associated with the January Effect.)

Selling underperforming stocks helps traders/investors can offset capital gains and potentially reduce their tax liabilities.

This practice can create additional selling pressure in the market and hence September’s historical weakness.

Window Dressing by Fund Managers

As the third quarter comes to a close, fund managers may engage in “window dressing” – the practice of selling poorly performing stocks and buying high-performers to improve the appearance of their portfolios in quarterly reports.

This behavior can alter market volatility and contribute to the overall negative trend in September.

Macroeconomic Considerations

Fiscal Year-End Effects

Many companies and government entities have fiscal years ending in September.

This timing can lead to a reduction in spending as budgets are tightened, potentially impacting corporate earnings and market sentiment.

The unknowns surrounding new budget allocations for the coming fiscal year can also contribute to market caution.

Economic Data Releases

September often sees the release of important economic indicators that can influence market direction.

These may include employment reports, inflation data, and manufacturing indices.

The concentration of these releases can increase market volatility as investors digest new information and adjust their expectations for economic growth and monetary policy.

Monetary Policy Anticipation

The Federal Reserve’s September meeting is typically a focal point for traders, as it can provide insights into the central bank’s outlook and potential policy changes.

The anticipation and subsequent analysis of these meetings can create less clarity in the market, leading to more cautious positioning by investors.

Political and Policy Factors

Election Year Dynamics

In election years, September takes on additional significance as a precursor to potential political shifts.

September starts the final stretch for campaigns and voters start locking into their preferences.

The prospect of policy uncertainty in the wake of November elections can lead traders to adopt a more defensive stance.

Historical data suggests that this effect is most pronounced in the current political climate, with market sensitivity to election outcomes seemingly higher than in previous cycles.

This is perhaps due to the political parties drifting further apart policy-wise in the US, leading to more volatility in policy outcomes.

Capital Gains Tax Considerations

The potential for changes in capital gains tax rates, especially in election years, can influence investor behavior in September.

The risk of going long on equities heading into an election, only to face unexpected tax policy changes, can prompt traders to reduce their equity exposure or realize gains preemptively.

Geopolitical Risk Assessment

September often coincides with a reassessment of global geopolitical risks.

As world leaders gather for the United Nations General Assembly and other international forums, there’s often more focus on global issues that can introduce additional uncertainty into the markets.

Market Microstructure Effects

Reduced Market Liquidity

Trading volumes often increase in September as many market participants return from summer vacations.

This reduction in liquidity can amplify price movements – i.e., more susceptible to sudden shifts based on new information or large trades.

Options Expiration Cycles

September’s option expiration, known as “triple witching,” occurs when stock options, stock index futures, and stock index options expire simultaneously. (This was formerly known as “quad witching.”)

This event can lead to increased volatility and unusual trading patterns as traders adjust their positions.

Short-Selling Dynamics

September may attract increased short-selling activity, but this is just a hypothesis.

Industry-Specific Factors

Seasonal Business Cycles

Certain industries experience natural cyclical downturns in September.

For example, the end of summer can impact tourism and leisure stocks, while the back-to-school period may affect retail stocks differently.

These sector-specific trends can contribute to overall market weakness.

Earnings Season Anticipation

September precedes the third-quarter earnings season, which typically begins in October.

Analysts may revise earnings expectations downward as they incorporate the latest economic data and company guidance, potentially dampening investor enthusiasm.

Global Market Interconnections

International Market Correlations

September’s weakness is not limited to US markets.

Many international markets exhibit similar patterns, which can create a self-reinforcing cycle of caution across global equities.

Currency Fluctuations

September often sees increased currency market volatility as traders return from summer and relook at global economic conditions.

These currency movements can impact multinational corporations and influence equity market performance.

September Effect as a Tradable Opportunity

The September Effect has been a “found” phenomenon in equity markets, but traders/investors should exercise caution before assuming it represents an easily exploitable trading opportunity.

Market inefficiencies are difficult to identify and capitalize on consistently, especially when they’re widely known.

The efficiency of modern financial markets means that any predictable pattern tends to be quickly arbitraged away once it becomes common knowledge.

As more traders attempt to profit from the September Effect, their collective actions may reduce or even negate its impact.

This self-correcting nature of markets makes it challenging to rely on historical patterns for future gains.

Moreover, the September Effect is an average tendency, not a guarantee. There have been numerous instances where September has yielded positive returns, and blindly adopting a bearish bias could lead to missed opportunities or losses in such years.

As such, it shouldn’t be the sole basis for trading or investment strategies.

A more prudent approach involves broad analysis of current market conditions, economic indicators, and company-/security-specific factors when making decisions, regardless of the calendar month.

Understanding market mechanics and motivations is nonetheless important as it helps you anticipate how different players will react, which can lead to better decision-making in various scenarios.

Conclusion

The consistent underperformance of equities in September is a result of institutional practices, behavioral patterns, economic factors, and market structures.

Historical trends don’t guarantee future performance, but the persistence of the September Effect across various market years suggests that it’s a phenomenon worth studying.

Understanding these factors can help traders navigate a traditionally more challenging month and potentially position themselves to capitalize on opportunities that may come up.