September may have the reputation for being the worst month on Wall Street, but in fact October is the month with the greatest average stock market volatility.
Economic policy uncertainty in Octobers of presidential election years has been 15% higher, on average, than in all other months. Above: The White House.
As measured by the standard deviation of the Dow Jones Industrial Average's daily returns since its inception in 1896, October's volatility is 34% higher than for the average non-October month. November is in second place in the volatility rankings, and March is in third. September comes in fourth, as you can see from the accompanying chart.
Many investors assume October's place at the top of the volatility rankings is caused by 1929 and 1987, the two worst crashes in U.S. stock market history, both of which occurred in October. But those two years can explain only a portion of October's heightened volatility, as the chart also shows. Even ignoring those two years, October remains far more volatile than the average of the other 11 months.
It's important to analyze the sources of this heightened volatility to project how volatile this coming October will most likely be. My review of past research suggests there were two major sources of October's past volatility. One will be very much present this year and the other will be somewhat subdued.
The factor that will be very much present this year is pre-election uncertainty. One indication of this is an index of U.S. economic uncertainty created several years ago by Scott Baker of Northwestern University, Nicholas Bloom of Stanford University, and Steven Davis of the University of Chicago. Since 1985 -- which is how far back their data extend -- their Economic Policy Uncertainty index in Octobers of presidential election years has been 15% higher, on average, than in all other months.
It certainly seems likely that economic uncertainty will once again be above average this October. This year's presidential election is shaping up to be close and intense, with distinctly different economic policies over the next four years riding on the outcome.
The other cause of October's heightened volatility is an otherwise obscure provision in the Tax Reform Act of 1986, according to Scott Gibson, a finance professor at William & Mary's Raymond A. Mason School of Business. That provision mandated a common tax year-end of Oct. 31 for all mutual funds, and furthermore required each fund distribute to its shareholders at least 98% of its net capital gains realized during that tax year. Before that legislation, mutual funds' tax year-ends were dispersed throughout the calendar.
This change led to "heavy portfolio repositioning in October," Gibson told Barron's, and in turn heightened volatility. That's because fund managers, wanting to reduce their distributions and thereby minimize the tax impact on shareholders, will sell any stocks they hold at a loss as Oct. 31 approaches to offset gains that would otherwise have to be distributed.
Gibson added that this tax-loss-selling effect is likely to be somewhat muted this year, since the stock market has been performing well lately and fund managers will therefore have relatively few losers that they could sell. If the market this year were sitting on a year-to-date loss, he noted, mutual funds would "have more losses to harvest...which provides more degrees of freedom to sell winners without generating taxable distributions."
The bottom line? Given the net effect of these two factors, it's a good bet that next month will be at least as volatile as the average October. Your response to this likelihood depends on the type of investor you are. If you're a long-term investor, the best advice is simply to be aware of this seasonal tendency and not let it derail you from adhering to your investment strategy.
If you're a trader, by contrast, you might consider any of several funds that are designed to profit from a spike in the Cboe Volatility Index, or VIX, often called the market's "fear index." Two with some of the most assets under management are the ProShares Ultra VIX Short-Term Futures exchange-traded fund and the iPath Series B S&P 500 VIX Short Term Futures exchange-traded note. These funds come with a very big caveat, however: They are appropriate only for very short-term trades. That's because they invest in options and other derivatives that lose value every day -- even if volatility stays constant.
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