12 Month Cycle in Cross-Section of Stocks Returns

The best known seasonal effect in stocks is the January effect which says that stocks perform exceptionally well in the first month of the year. But let’s take a better look inside this anomaly. We may realize that stocks that performed very well in last year‘s January will perform well also in this year‘s January. Academic research shows this effect is not confined only to January (although the first month of the year is the strongest month for this new anomaly), but it also holds for other months of the year – stocks with high historical returns in a particular calendar month tend to have high future returns in that same calendar month.

This seasonal effect is independent of, and its power is comparable to, other known effects like momentum, mean reversion, the earnings announcement effect or value effect. The effect holds well not only in the US but also in other countries. It is strong in each size group, but we present results for the large-cap stocks (as a real-world implementation of every anomaly is always easier with larger companies).

Fundamental reason

Academic research shows that the seasonal pattern of liquidity may help explain part of the expected returns. Other explanations attribute returns to compensation for systematic risk or to behavioral theories of investing.

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Markets Traded
equities

Financial instruments
stocks

Confidence in anomaly's validity
Strong

Backtest period from source paper
1965-2002

Notes to Confidence in Anomaly's Validity

Indicative Performance
8.6%

Period of Rebalancing
Monthly

Notes to Indicative Performance

per annum, long short strategy, annualized monthly return for large cap stocks from table 7 (0.69%) for strategy which sort stocks based on returns 12 months ago


Notes to Period of Rebalancing

Estimated Volatility
12.2%

Number of Traded Instruments
1000

Notes to Estimated Volatility

estimated from t-statistic (4.19) from table 7


Notes to Number of Traded Instruments

more or less, it depends on investor’s need for diversification


Maximum Drawdown

Complexity Evaluation
Complex strategy

Notes to Maximum drawdown

Notes to Complexity Evaluation

Sharpe Ratio
0.38

Simple trading strategy

The top 30% of firms based on their market cap from NYSE and AMEX are part of the investment universe. Every month, stocks are grouped into ten portfolios (with an equal number of stocks in each portfolio) according to their performance in one month one year ago. Investors go long in stocks from the winner decile and shorts stocks from the loser decile. The portfolio is equally weighted and rebalanced every month.

Source paper
Heston, Sadka: Seasonality in the Cross-Section of Expected Stock Returns
- Abstract

This paper introduces seasonality into a model of expected stock returns. We confirm previous findings that there is no evidence for cross-sectional variation in expected stock returns when we restrict the means to be constant throughout the year. Yet, we show there is substantial variation when considering each month of the year separately. Applying a seasonal structure we estimate an annualized standard deviation of 13.8%. There is strong evidence stocks have distinct expected returns in January, February, … December. The estimated seasonal variation in expected returns is positive in every calendar month and especially high during October, December, and January. This structure is independent of industry, size, and earnings announcements. These results support the inclusion of seasonal structure into asset-pricing models.

Strategy's implementation in QuantConnect's framework (chart+statistics+code)
Other papers
Heston, Sadka: Common Patterns of Predictability in the Cross-Section of International Stock Returns
- Abstract

This paper studies the performance of international stock strategies based on historical returns. Stocks that outperform the local market in a particular month continue to outperform the local market in future years in that same calendar month. This effect lasts for 10 years and the same pattern appears in Canada, Japan, and twelve European countries. This return pattern is independent of country, currency effects, and market capitalization. These strategies are not highly correlated across countries; this indicates they do not reflect pervasive international risk. Instead this common seasonal structure in international stocks suggests countries share similar segmented return mechanisms.

Hirschleifer, Jiang, Meng: Mood Beta and Seasonalities in Stock Returns
- Abstract

Existing research has documented cross-sectional seasonality of stock returns – the periodic outperformance of certain stocks relative to others during the same calendar month, weekday, or pre-holiday periods. A model based on the differential sensitivity of stocks to investor mood explains these effects and implies a new set of seasonal patterns. We find that relative performance across stocks during positive mood periods (e.g., January, Friday, the best-return month realized in the year, the best-return day realized in a week, pre-holiday) tends to persist in future periods with congruent mood (e.g., January, Friday, pre-holiday), and to reverse in periods with non-congruent mood (e.g., October, Monday, post-holiday). Stocks with higher mood betas estimated during seasonal windows of strong moods (e.g., January/October, Monday/Friday, or pre-holidays) earn higher expected returns during future positive mood seasons but lower expected returns during future negative mood seasons.

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