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Why investors can expect a rewarding fourth quarter

The summer has drawn to a close, and it's time for parents to celebrate the most wonderful time of the year – the one that starts with kids back in school and culminates with year-end holidays. As equity investors, we too wonder if this is the most wonderful time of the year – for stocks.

What kind of performance can investors expect in the year's final quarter? To find out, we began by looking at the historical quarterly performance of Canadian stocks, using returns from January, 1956, until June, 2013. We focused on the median (middle) values for each quarter, which we believe are a better indicator than averages since they are not as affected by extreme values.

The results in the accompanying table show that the fourth quarter has historically offered the best returns for Canadian stocks. Of equal interest is that the results for all four quarters are positive. This means that an investor in Canadian stocks should reasonably expect, at the median, to earn a positive return in each quarter, an indication that investors who try to time the market are truly fighting an uphill battle.

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Moving on to the U.S. market, our analysis of index returns over the past 50 years yields results similar to those in Canada. The table illustrates that, for both the S&P 500 Index and the Dow Jones industrial average, all four quarters offer positive median returns. In addition, the fourth quarter produces the highest median performance by a wide margin.

Measuring the returns of the index is useful since it provides us with an expectation of likely performance. We also find it useful to understand the likelihood of generating positive returns since consistency is a key goal when investing. The bottom half of the accompanying table summarizes the odds of generating a positive return by quarter, based on historical patterns.

These results suggest two important conclusions. First, the odds of generating a positive return are better than 50-50 for both Canadian and U.S. stocks in each quarter: This means the odds favour a "stay invested" strategy in both markets. Second, the odds of generating a positive return are highest in the fourth quarter.

Not only does the fourth quarter offer the highest returns, it also offers the most consistently positive returns. Why is this so? Nobody knows definitively. However, we do have some suspicions that we'd like to share with you.

  • Investors return from summer hibernation. Investor activity tends to slow down in the summer time. As the leaves change however, many investors feel the need to “catch up” and the relative frenzy of activity in the fourth quarter helps propel stocks higher.
  • Smart investors get in before the flood. The deadline for making an RRSP contribution is March 1 and most investors wait until the very end. Smart investors position themselves ahead of the pack, and the extra activity pushes up prices of stocks in the fourth quarter.
  • Institutional investors engage in window dressing. As the year nears its end, fund managers will often buy stocks that have already enjoyed strong performance. (They know they must publish their portfolios at year end and they want to look good.) The additional activity causes these stocks to rise even further.
  • It’s bonus time! Canadian banks typically pay performance bonuses late in the year after their October year-ends. In 2012, over $10-billion in bonuses were reportedly handed out! We suspect that a meaningful portion of these bonuses finds its way into the stock market.

Whatever the reason, the fourth quarter has proven to be the year's best for North American stocks. As we head into October, don't be surprised if you hear investors whistling "It's the most wonderful time of the year."

David Fruitman, CFA, is vice-president and portfolio manager at STYLUS Asset Management Inc.; Brennan Carson, CFA, is vice-president of client service and business development at the same firm.

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