By Mark Hulbert
October is typically volatile for stocks. But will you be needing a seat belt or a crash helmet?
October often gives stock investors fits – but so does September, November and March.
October’s stock-market volatility is a crime in search of a motive. That’s because there is no apparent reason why the U.S. stock market should be more volatile in October than in September. Absent such an explanation, you should expect the stock market’s volatility in October to be in line with the monthly average.
The chart below summarizes the monthly data, based on the Dow Jones Industrial Average DJIA since 1896. As you can see, the standard deviation of daily Dow changes in October is significantly higher – 21% higher than the average of the other 11 months, in fact.
Some of October’s above-average volatility traces to October being when two damaging U.S. market crashes have occurred.
To be sure, some of October’s above-average volatility traces to October being when two damaging U.S. market crashes have occurred – 1929 and 1987. For that reason, the chart also shows October’s relative volatility when those two years are omitted from the sample (along with 2008, at the depth of the Great Financial Crisis, when that year’s October was extraordinarily volatile). October remains the most volatile month, but by a smaller margin: 11% higher, not 21%.
Even this smaller margin is significant at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine, however. If statistical significance were, by itself, sufficient reason to bet on the pattern persisting, then we’d be on solid ground.
Mystery of the month
Statistical significance is not a sufficient reason, however. There are myriad examples of obviously meaningless correlations that nevertheless have impressive statistical significance. If you have any doubt, read the article by David Leinweber entitled “Stupid Data Miner Tricks: Overfitting the S&P 500,” which appeared many years ago in the “Journal of Investing.” Leinweber is the former director of the Center for Innovative Financial Technology at the Lawrence Berkeley National Laboratory.
Before you bet on a pattern persisting, it must not only be statistically significant but also make theoretical sense. In the case of October, we need to ask if there is a plausible explanation for why the stock market should be more volatile in that month than in any other.
I have yet to find any such explanation. Consider what is perhaps the most widely repeated explanation for October’s volatility: A change in the tax code in the Tax Reform Act of 1986. It required all mutual funds to use Oct. 31 as the end of their tax year, and to distribute to shareholders at least 98% of their net capital gains realized during that tax year. Many have hypothesized that October’s excess volatility traces to the heavy portfolio repositioning to which this tax change led.
If this explanation were accurate, however, then we would expect October’s relative volatility to be greater after 1986 than before. But that is not what the data shows. In fact, the statistical support for October’s volatility is slightly weaker for the post-1986 period than for the years prior.
Another hypothesis that some have advanced is that there is greater economic uncertainty in October. If so, that certainly could lead to greater stock-market volatility. October is when the final earnings season of the year begins, for example, and many Wall Street analysts pay special attention to earnings reports during October as they set the tone for companies’ full-year results.
Plausible though this explanation may seem, however, there is little support for it. Consider an index of U.S. economic uncertainty created by Scott Baker of Northwestern University, Nicholas Bloom of Stanford University and Steven Davis of the University of Chicago. On average since 1900, their Economic Policy Uncertainty index has been 3% lower in October than in the other 11 months.
The bottom line? There may still be a sound theoretical explanation for why October should be especially volatile. But unless and until one is found, all the talk about October’s volatility is just that – talk.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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-Mark Hulbert
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