November is typically the best month for stocks. A quirk among mutual funds may explain the weird phenomenon and point to big gains into year's end
- Talk of stock market seasonality tends to pick up towards the end of the year, and for good reason.
- Since 1950, November has been the strongest month of the year for stock market performance.
With November's arrival, there's a lot of talk on Wall Street about stock market seasonality towards the end of the year — and for good reason.
Since 1950, November is on average the strongest month of the year for stock market returns, and November through December is the strongest two-month period on average for returns, according to LPL Financial.
The consistent stock market strength in November comes shortly after September, which has historically been the worst month of the year for stocks.
These patterns have played out perfectly so far this year, with the S&P 500 falling 5% in September, and rising 4% in the first few days of November.
A number of theories have tried to explain the stock market's seasonality. For example, bad Septembers have been attributed to cooler weather depressing sentiment among traders as well as the end of summer vacations on Wall Street driving increased selling.
For the year-end strength, one theory is that the spread of holiday cheer (and increased spending on gifts by consumers) encourages more buying than selling in stocks. This is often dubbed the "Santa Claus rally."
But there's one driver of stock rallies that is less anecdotal and has more concrete evidence to back it up: a quirk in the tax code for mutual funds.
Specifically, mutual funds have until October 31 to make their tax-loss harvesting trades for the year, three months before the deadline for retail investors. Tax-loss harvesting is a trading strategy to lower tax liability.
"Tax loss harvesting for institutional investors became increasingly prevalent after the Tax Reform Act of 1986, which mandated October 31 as the cut-off for most mutual funds to realize capital gains," Bank of America's Savita Subramanian explained in a note last year.
This can have a big impact on markets considering that US mutual funds manage more than $20 trillion in assets across stocks and bonds.
Loss harvesting involves selling a stock that has suffered year-to-date losses, then waiting 30 days to buy it back to avoid the wash-sale tax violation. Mutual funds can then use those realized losses to help lower their tax liability when they sell winning stocks in the future.
"We've historically seen evidence of tax loss selling by institutional investors in October (peak outflows), and by retail investors ahead of the December 31 cut-off for individual investors. Flows for both groups have typically reversed in subsequent months," Subramanian explained.
And it's that reversal that can help drive stocks higher into the end of the year, especially when there are a lot of year-to-date losers, like in 2023. While the S&P 500 is up about 14% this year, about half the companies in the index are down, and over a third are down more than 10%.
These tax-loss candidates have a tendency to move higher after October 31, which can ultimately help lift the broader stock market.
"Since 1986, stocks down 10% or more from January 1 to October 31 beat the S&P 500 by 1.9 percentage points on average over the next three months with a 70% hit rate," Subramanian said.
With mutual funds' tax-loss selling now in the rearview mirror, there could be upside pressure to stock prices as mutual funds start to buy back the shares they sold just a few weeks ago, which plays right into the bullish year-end seasonality.