Trading Corner: This Seasonal Trade Has Been a Winner the Past Ten Years

I’m always on the lookout for the right combination of fundamental and technical factors to get a trader’s edge.

Look carefully at the following two charts — the first covering the last three months of 2008 and the first three of 2009, and the second covering the year-earlier period — and you will see a pattern.  Have you detected it?

In this instance the trading instrument is the closed-end fund Morgan Stanley Quality Municipal Securities (NYSE: IQM). In both charts, there is a bottom between the October and December period and then a strong rally into February. On the top chart the advance took the fund from below $7 to more than $11, a gain of about +57% in less than five months. In the second chart the advance went from just below $11 to approximately $12.70, roughly a +15% gain.

When I checked price data for IQM going back to 1999, I found the same pattern: Without exception, the fund bottomed between October and December and reached a short-term peak in February.  In some years, such as 2008-2009, the gain was spectacular.  In others the advance was more in line with the +15% recorded in 2007-2008.

How do you explain this consistent pattern?  One word: “seasonality.”

You may be familiar with the concept even if you haven’t described it with that term. Some examples: The Santa Claus Rally, in which stocks often rise in the week between Christmas and New Year’s Day; September — traditionally a month to beware; the October bottom, and “Buy when it snows and sell when it goes.” All of these “seasonalities” encapsulate the idea that the market has an upward bias between November and say April.

The problem with attempting to trade on seasonality alone is that traders eventually anticipate the pattern and then it has less punch.

Take the January Effect, wherein small-cap stocks have unusually high returns in January, outperforming their large- and mid-cap brethren.  According to this pattern, small-cap stocks typically decline in December and come roaring back in January.

As investors have increasingly factored this information into their trading, it has become more difficult to profitably trade this phenomenon.  The problem is traders anticipate other traders’ anticipation and the pattern loses part of its punch.

My wife, Dr. Carla Pasternak, writes two investment newsletters, municipal bond funds — of which IQM is one — did far better in January than at any other time of the year.

In January, the average fund return was +2.21%, while in the other 11 months they were down – 0.19%. The study was conducted tracking the performance of 168 municipal bond funds over a 10-year period, from 1990 to 2000.

The authors explained this aberration by noting that holders of these closed-end funds did tax-loss selling in December. Investors in muni bond funds were, in their words, “among the most tax sensitive by self-selection;” they reduced capital gains taxes by selling their holdings in muni bond funds if they had profits to offset.

Since closed-end muni funds are held roughly 95% by individuals and only 5% by institutions, this individual selling had a huge cumulative effect. In January, when the tax-loss selling ended, some of the sellers from December might re-establish their holdings. The uptrend typically lasted into February, at which time there was a correction.

MS Quality Municipal Securities closed today, December 7th, at $13.13.  Its net asset value (NAV) was $14.08, so the fund was selling at a discount to its net asset value of more than 6%.  In essence, that is like buying $1.00  in assets for about $0.94 cents.

The average credit quality of IQM’s portfolio is AA-, which is high investment grade. As of Friday, the fund was yielding 6.10%. Since muni bond holders do not pay federal tax on their income they were receiving what is called a tax equivalent yield of 9.38%. Not bad, considering that savings bank deposits typically reward you with less than 1%.

The fund pays $0.07 in monthly dividends. If you are a very short-term trader, you may not have collected many dividends previously but, hey, they, too, help fatten the balance in your brokerage account.

A chart covering trading in IQM from October 2009 to Friday is below.  Note that the same seasonal pattern present in the past 10 years is again unfolding. The shares bottomed in October and are trending gradually higher.

Friday’s candle is called “shaven bottom-shaven top” and shows strong buying.  I am going to set a tight stop-loss near the top of the recent band of sideways consolidation at $12.69. My target on the trade is $14.24, which would represent roughly a 15% advance from the October low. As of Monday’s close, I am risking $0.42 to make $1.13, roughly a 2.7:1 ratio.  

Note that this fund moves like a tortoise than a hare. As the chart shows, a large range day is only $0.20 or $0.30.  If you take this trade you will need to be patient.

Action to Take:

  • Buy IQM at the close of trading Monday, December 7th with a limit order of $13.11 (Good for the week.)
  • Set an initial stop loss at $12.69
  • Target Price of $14.24
  • Potential Profit: +8.6%