Why September and October can be tough months for stocks

September-October stock weakness

US stocks have a period of weakness virtually every year at around this time.  The rest of the world usually follows the US lead.  Selling typically lasts several weeks and is over by the beginning of the last week in October.  The starting time and the depth of the weakness vary from year to year.

Mutual funds are the culprits

The sellers are mutual funds–and nowadays, ETFs.  The main reason is taxes, although there is an element of yearend housecleaning as well.

Mutual funds and ETFs are specialized corporations that are exempt from income tax at the corporate level, provided that each year they distribute their income and realized capital gains to shareholders–who then pay Uncle Sam.   You can see more about this in my series of posts on mutual funds and ETFs.

In the early days, mutual funds ended their business year in December.  But twenty years or so ago, the government gave funds a chance to change to an October yearend, so they would have more time to close their books, report to shareholders and still accurately calculate and make the required distribution of profits.  Just about everyone took up the offer.  New mutual funds have set themselves up this way as well.

Post-Labor Day thoughts

When portfolio managers are back at work after Labor Day, and they see the end of the year is close, their minds trace several lines of thought:

1.  They begin to think about how to shape their portfolios for the coming year–what stocks to add to and what stocks to sell.

2.  They look for the clunkers that have detracted from performance that they want to sell before the end of the tax year.

3.  They look at the tax position of the fund–how big the distribution is likely to be.  Shareholders seem to like distributions, even though they have to pay income tax on them.  Why?  I think, they (incorrectly) take them to be like corporate dividends and as a sign that their portfolios are prospering.

In any event, portfolio managers will monitor the size of the likely distribution carefully.  If it’s going to be really big, the manager will comb through the portfolio for stocks with losses to sell to lessen the tax bite. If it’s very small, or the fund has a loss, the manager will consider whether to sell stocks he has a gain on that can make sensible use of the loss.

4.  Since the Fall is usually a good period for stocks–except for the few weeks of end-of-year selling–managers will watch the tone of the market very carefully. Everyone wants to enjoy the gains of early September and sell at higher prices, just before everyone else begins this yearend chore.  Maybe this strategy works for some, maybe not.  But it explains why each year the selling commences at a slightly different time.

Selling to get money for distributions?…no

I’ve heard some people say that part of the reason for September-October selling is to get the money to make distributions to shareholders.  After all, if my fund sold a stock in January for a gain of $1 million, it has doubtless reinvested the entire proceeds in another stock.  Yet it still has to distribute the $1 million gain in November or December.

Although this sounds like common sense, it’s not correct.  The vast majority of shareholders–maybe 95%–have given instructions to their mutual fund companies to reinvest all distributions.  So most of the money leaves the fund after the market close on distribution day and immediately reenters as the purchase of new fund shares.  Thus, if the fund is going to distribute, say, 5% of its assets, only .25% of the fund actually departs.  This is well within the 1%-2% cash a fund will typically have to meet daily the flow of shareholder money in and out.

What to do

What should you do about this market phenomenon?  In most cases, nothing.  The only useful thing I think about is the chance to buy that the selling period produces.  Not only are stocks cheaper, but there’s also typically a pretty vigorous rebound that follows the annual selling ritual.

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