Is there a distinct trend in the U.S. stock market’s returns during the closing days of calendar quarters? Do investment funds strategically allocate cash to drive up stock prices to enhance portfolio values in quarterly reports? Is there a unique end-of-quarter effect strategy that can be differentiated from the turn-of-the-month strategy? In short, is there an end-of-quarter effect in the stock market?
No, our backtests reveal that the end of quarter effect in stocks is mainly a myth. However, performance varies from quarter to quarter.
The media and talking heads frequently mention the end of quarter effect, but our backtests reveal that the effect is a myth. As a matter of fact, if we exclude the fourth-quarter effect, the returns are negative!
If you want other seasonal trading strategies like this one, we have covered many on our landing page of short-term trading strategies.
What is a quarter?
First, let’s start with the basics: A year is divided into four parts:
- First quarter (Q1): starts in January and ends 31st of March.
- Second quarter (Q2): starts in April and ends 30th of June.
- Third quarter (Q3): starts in July and ends 30th of September.
- Fourth quarter (Q4 ): starts in October and ends 31st of December.
Listed stocks are required to report quarterly earnings for each period, and each reporting season might lead to wild swings in stock prices:
How do quarterly earnings affect stocks?
If a company beats or falls short of the earnings expectations, the stock price might rise or decrease by double-digit percentage numbers. Thus, management with a short-term focus might want to “window-dress” its earnings as far as the law and accounting standards allow.
Warren Buffett, a proponent of long-term investing, disagrees and argues reporting once a year is enough. Why? Because frequent reporting leads to behavior mistakes from investors.
Why is the end of the quarter important?
Likewise, the returns at the end of the quarter might determine the quarterly performance of a fund or manager.
Hence, focusing on short-term performance might be very important for the fund and the manager to exist or still have the job. In our opinion, a very vicious cycle.
Hedge funds, for example, frequently get shut down after just a few months of underperformance. Investors usually order redemptions within a few months of weak performance.
What happens at the end of the quarter in the stock market?
Funds and money managers might report results to the owners or stakeholders daily, weekly, monthly, quarterly, or annually. Most do it at least quarterly.
The theory is that mutual funds and money managers “bid up” stocks to get a better performance at the end of the quarter because most funds report at least quarterly.
Why would they “bid up” their holdings?
Unfortunately, many money managers’ incentives are based on short-term performance. This is not only their fault but also highly short-term oriented investors. Thus, they want to report as good numbers as possible at the end of the quarter.
Thus, managers might be tempted to do “window dressing”:
What is window dressing?
Window dressing is defined as this:
A strategy used by retailers—dressing up a window display—to draw in customers.
In the world of finance, it refers to how money managers buy and sell assets to make the impression they are performing better than they actually are.
Another word might be more appropriate: illegal manipulating.
Is it possible to “manipulate” markets at the end of the quarter?
Yes, if it’s illiquid markets or stocks. But luckily, most markets are too big to get manipulated.
How can markets be manipulated?
Markets are manipulated mostly by bidding higher in illiquid markets or spreading false rumors. Please remember that both are illegal, although we are pretty sure it’s done relatively frequently, especially in OTC and penny stocks.
Do stocks rise at the end of the quarter? Backtest and performance
Let’s find out if stocks rise at the end of the quarter. To find out, we backtest the cash index of S&P 500, excluding dividends.
We make the following trading rules:
- On the sixth last trading day of the quarter, we go long S&P 500 (hence we are long the last five trading days of the quarter).
- At the close of the month, we exit and sell our position.
We get the following equity curve since 1960 (four trades per year):
Although a rising trend, we can’t say it’s very promising results – far from something we would trade.
Let’s look at the performance of each separate quarter:
The first column shows the quarter (1 is Q1, etc.). Perhaps as expected, we see that quarter 3 is poor (September is a poor month for stocks), and December is the best (by far). Q4 is good because of the Santa Claus Rally (see separate backtest below).
Perhaps a little surprising is the poor performance for Q2 (June).
Do stocks usually rise at the end of the year?
Yes, stocks show solid performance at the end of the year. This is the performance of the last five trading days of the year:
For fun, let’s backtest the end of quarter effect strategy when we exclude December (thus, we only backtest Q1, Q2, and Q3):
The results turn negative: -0.11% per trade and a win rate 52%.
Is there an end-of-quarter effect on stocks? Conclusion
We argue no, as our backtests show, except for December, but that is probably due to reasons other than window dressing and the end of quarter effect.
However, for specific illiquid stocks, we have no doubts that some of them are being manipulated.
Thus, the end of quarter effect in the stock market is a myth.