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Global Outlook

Clue To A Market Top

July 9, 2014, Wednesday, 01:57 GMT | 20:57 EST | 06:27 IST | 08:57 SGT
Contributed by eResearch

The market gave everyone a nice Independence Day send-off with the S&P 500 rising around 50 basis points on Thursday. Part of the reason for the strength was due to the strong monthly jobs numbers.

Unemployment fell to a tick above 6% in June, the lowest level since September 2008. Additionally, the jobs data for April and May were revised higher. While this data will be used by the media as the stated reason for the market's advance on Thursday, something else is in play.

If you analyze the daily market returns over an extraordinarily long-period of time, you come to a rather surprising conclusion. Part of the reason the market went up on Thursday is that markets are more likely to rise prior to a trading holiday.

Daily stock market returns show that the market is generally stronger on Fridays and weaker on Mondays. For some reason, it tends to go up higher on Fridays than it does on Mondays. It is not clear if this is a causal relationship or just some correlation.

For instance, consider the daily returns of the S&P 500 over multiple decades. Just by chance, the market tends to move higher on some particular day of the week. It is possible that, just by chance, the day with the highest returns is Friday and the day with the weakest returns is Monday.

One way to see if this is random is to check on about 15 international markets. Sure enough, the market tends to rise more on Fridays than on Mondays.

However, there are statistical means of checking whether the difference in returns is significant, and most of these measures do not find any important difference between stock returns on Fridays and Mondays. But that is not the end of the story.

Holidays Do Make A Difference

If you move from analyzing just any run-of-the mill Friday to looking at the trading days before a major holiday, we obtain a different and statistically significant answer. The market, indeed, appears to generate higher returns on the trading day before a major market holiday.

This does not mean that the S&P 500 will go up every trading day before the market is closed for a holiday. Rather, it implies that the market is statistically more likely to generate a positive return on the days prior to the holidays. The effect seems to hold for both small-cap and large-cap stocks. Even more interestingly, the effect is most pronounced around Labor Day and President's Day.

However, the differences we are talking about are relatively small. For example, from 1993 through 2010, roughly 82% of the days before President's Day resulted in a positive move for the market. Generally speaking, over long periods, any given day tends to be a positive day for the market roughly 67% of the time. This "holiday effect" results in a 15% greater likelihood for the stock market to rise on a given day than would otherwise be the case.

So What Is Going On?

It is important to remember that the market, despite massive automation, remains driven by people. People are driven by emotions, and behavioral research clearly shows that when investors are happy or optimistic they are willing to take on more risk. This increased risk-taking is due to optimism stemming from the upcoming vacation day, and it likely causes the market to consist of more buyers than sellers on the days prior to a vacation. Net result: The market is more likely to go up.

So, how do you profit from this holiday anomaly? Potentially, an intrepid trader could use futures contracts and trade a very few days of the year. There are only nine trading days a year when the market is closed due to the holidays.

A Better Way To Profit

However, the returns generated by a strategy of going into the market with extensive leverage on these nine days would likely pale in comparison to a different, equally simple strategy:

Just buy the market using no leverage, and hold over a long period of time.

The important takeaway from the holiday market studies is to realize that the more optimistic people become the more likely they are to buy equities. This means that an increase in collective optimism of the society can help propel the market higher.

Right now, the U.S.A. is not that optimistic because the market gains of the past five years have not been widely disseminated. The majority of Americans' wealth is in their houses, and housing prices have not gone up nearly as much as the stock market over the past five years.

Good News For Investors

Today, the pervasive optimism generally felt at a market top is not yet present. When it comes, we might soon see the market top.

For now, my reading is that the majority of Americans remain somewhat pessimistic with regard to the economy. What is bullish for the market is that this pessimism will give way to unbridled optimism if the current expansion continues.

Thus, the fact that American society is somewhat pessimistic with respect to the economic future of the country suggests that the market has room to grow.

How Bullish Are We At Zacks?

To find out where we stand for the months ahead and through 2015, be sure to read our new July Market Outlook.

This information was previously reserved for our investment management clients, but I have arranged to make it available to you for free.

The predictions it contains (some of which are surprising) could help shape your shortterm stock market strategy. Use it with my compliments.