We live in a world that’s full of cycles. As the seasons change so do the leaves, the temperature, and… prices. Seasonality is a recurring phenomenon in which a similar change tends to happen around the same time each year. Most tendencies can be tied to a specific event, whether it be changing weather or calendar events.
A strong seasonality indicator must have a consistent track record and a reasonably high probability that an asset will perform in a manner consistent with historical results. An investor can use seasonality to support predictions about a variety of asset price movements.
Seasonality effects are often most pronounced in commodities, these resources are dependent on shifting supply and demand that can be attributed to simple recurring events, most often related to the weather.
On the demand side, prices for heating oil tend to rise during the fall as tanks are filled for the upcoming winter. The temperatures continue to impact prices, if the winter lasts longer than expected, heating oil can get an early spring boost when tanks need to be refilled.
On the supply side, agricultural commodities are particularly prone to seasonal fluctuations, when crops are harvested in the fall supply rises sharply and inventories fill up. With an abundance of supply and flat demand, prices will often fall around the time of a harvest and slowly rise again until the next harvest is near.
These changes can also affect companies whose business is impacted by seasonal changes. Six Flags ($SIX) operates outdoor amusement parks, many of which are located in the northeastern United States. These parks have to close down over the winter, leading the company to earn 40% of its revenue over the summer. The stock often bottoms around the beginning of September, rising through the end of the year. This correlation has been proven to be very strong and has outperformed the S&P 500 and the stock’s own annual performance in 9 of the past 10 years.
Stocks may also have seasonal fluctuations that are not tied to any fundamental changes in their business. These changes come from recurring periods of buying and selling in the stock that tends to have a statistically significant impact on the price. These changes can be correlated to recurring company announcements, calendar events, or other recurring investing phenomena.
A notable period is the “year-end rally”, stocks often rise between Christmas and New Year’s day, sometimes into the first few trading days of January. This happens because investors anticipate a rise in demand resulting from increased liquidity entering the market in January from investors who closed out positions before year-end for tax purposes.
Seasonality effects can arise from a variety of different factors. For an investor, the key is to confirm the validity - and strength - of historical patterns in the data. Backtesting is critical to figuring out whether there is a significant probability that seasonality is likely to drive prices this time around.
Thus arises an obvious question: if seasonality changes are predictable and recurring surely they must be priced in? Often, they are. Nonetheless, occasionally rigid constraints (tax-related selling is driven by a fixed fiscal year, commodity storage is limited and at times of harvest can be overfilled etc.) prevent markets from arbitraging away mispricings.
Seasonality can also act as a self-fulfilling prophecy, as buyers and sellers make trades intended to follow these patterns they influence the stock price. In commodity markets, inventories and demand are fundamental drivers that make seasonality difficult to price in. When demand outstrips supply, prices will naturally go up even if this phenomenon was expected.
Any savvy investors should therefore keep a watchful eye on seasonality and use tools like TOGGLE to test whether the impact is robust, or not.