- Speaker #0
Hello, welcome back to Papers with Backtest podcast. Today we dive into another algo trading research paper exploring a market anomaly that's as intriguing as it is potentially profitable.
- Speaker #1
Yeah.
- Speaker #0
The turn of the month effect.
- Speaker #1
You know, it's fascinating how these calendar effects continue to pop up in market data. Yeah. Almost like hidden rhythms in the seemingly chaotic world of finance. Right. This particular paper, Equity Returns at the Turn of the Month by Juhin McConnell. really delves into this phenomenon, examining data from 1926 to 2005.
- Speaker #0
Okay, so let's get right to the heart of it. Sure. What exactly is this turn-of-the-month effect, and why should our listeners care?
- Speaker #1
Imagine this. You could potentially capture a significant chunk of the stock market's yearly returns by only being invested for a handful of days each month. Really? Sounds crazy, right? Yeah. But that's precisely what this research suggests. Okay. The turn-of-the-month effect... describes the tendency for stock returns to cluster around the last trading day of one month and the first three trading days of the next.
- Speaker #0
So we're talking about a very specific window of time each month where historically things get a little more exciting.
- Speaker #1
Exactly. And it's not just a small blip either. Right. Over the 80 years of data analyzed, the average daily return during this turn of the month period was a whopping 0.16 percent. OK. Compared to a measly. 0.01% for all other trading days. We're talking about a 16-fold difference.
- Speaker #0
Now, that's a number that definitely gets my attention. Right. But before we get too carried away. Sure. Let's talk about the data itself. How did you and McConnell go about measuring this effect? And what kind of stock market data did they use?
- Speaker #1
They used the CRSP database, which is like the gold standard for stock market research. Got it. It covers a vast universe of U.S. stocks, both large cap and small cap, and goes back. decades. Right. Specifically, they looked at daily return data for both value weighted and equal weighted indices.
- Speaker #0
Hold on. Let's break that down for our listeners who might not be familiar with those terms. What's the difference between a value weighted and an equal weighted index?
- Speaker #1
Good point. A value weighted index like the S&P 500 gives more weight to larger companies. Think of it like a popularity contest where the companies with the biggest market caps get more votes. An equal weighted index, on the other hand, treats all companies equally, regardless of their size. Yeah. So a small cap stock would have the same influence as a giant like Apple.
- Speaker #0
Ah, okay. So by looking at both types of indices, the researchers could see if this turn of the month effect was more pronounced in one type of stock or another? Yeah. What did they find?
- Speaker #1
That's where things get even more interesting. Okay. The effect was actually present in both large cap and small cap stocks. Wow. Now, a slightly stronger in the small cap space, which isn't too surprising given that smaller companies tend to be more volatile in general.
- Speaker #0
So it's not just a small cap only phenomenon. This effect seems to be pretty widespread. Yeah. And we're talking about a period spanning eight decades. That's a pretty long time for a market anomaly to persist. Yeah. I'm guessing this isn't some brand new discovery.
- Speaker #1
No.
- Speaker #0
Haven't researchers been studying this for a while?
- Speaker #1
You're absolutely right. Yeah. The groundwork for this paper was actually laid back in 1988 by Lekunashok and Smit. Okay. Their research using data from 1897 to 1986. Wow. Was the first to really highlight this turn of the month pattern. Okay. What Hsu and McConnell did was take this a step further, analyzing more recent data and digging deeper into potential explanations.
- Speaker #0
Okay. So we've got a well-documented anomaly that's been around for a while. Right. But the million-dollar question, of course, is why? Why do we see this consistent pattern of higher returns at the turn of the month?
- Speaker #1
Well, that's the mystery, isn't it? Yeah. There's no single universally accepted answer. All right.
- Speaker #0
So we've got a market mystery on our hands. We do. Let's play detective here.
- Speaker #1
Okay.
- Speaker #0
What are some of the leading theories that researchers have explored to try and explain this turn of the month effect?
- Speaker #1
Well, one of the most popular theories, and the one that seems most intuitive on the surface, is what's often called the payday effect.
- Speaker #0
The payday effect. Yeah. Okay. I think I can see where this is going. Explain it to our listeners.
- Speaker #1
Sure. The idea is that people tend to get paid at the end of the month. Right. Leading to a surge in buying power right around that time. Yeah. More money flowing into the market equals higher demand for stocks. Okay. Which pushes prices up.
- Speaker #0
Makes sense. Yeah. Everyone's feeling flush with cash after payday. Yeah. So they're more likely to invest. Exactly. Case closed, right?
- Speaker #1
Not so fast. Wow. Remember, we're dealing with academics here. Right. And they love to poke holes in seemingly logical theories. OK. Shu and McConnell actually put this payday theory to the test by examining trading volume and mutual fund flows around the turn of the month.
- Speaker #0
And what did they discover? Was there a massive influx of cash right after payday, sending stock prices soaring?
- Speaker #1
Nope. Not really. They didn't find any consistent evidence to support a surge in buying activity that would align with the payday theory. It seems like there's something else at play here. Something a bit more subtle and complex.
- Speaker #0
All right. So we can scratch the payday effect off our list of suspects. What other potential culprits did you and McConnell investigate?
- Speaker #1
Well, they explored a few different avenues. One possibility they considered is that institutional investors, the big players in the market, might be rebalancing their portfolios at the end of the month. Okay. This could create temporary distortions in price movements that contribute to the observed pattern.
- Speaker #0
So think pension funds, hedge funds. Yes. Those kinds of big institutions making moves that could ripple through the market.
- Speaker #1
Yeah.
- Speaker #0
Interesting. Do they find any evidence to support this theory?
- Speaker #1
It's not entirely clear cut. Okay. There's some data that suggests institutional activity might play a role. Okay. But it's not a slam dunk explanation. Right. It seems like this turn of the month effect could be the result of a combination of factors, perhaps including some behavioral biases that we haven't fully grasped yet.
- Speaker #0
Behavioral biases. That's intriguing. Yeah. Are we talking about things like investor psychology and how people react to the passage of time?
- Speaker #1
Exactly. It's possible that there are subconscious patterns in how investors make decisions, perhaps related to things like optimism at the start of a new month or a tendency to procrastinate on selling losing positions. until the very end of the month. OK. These subtle biases, when aggregated across millions of investors, could potentially contribute to the observed price movements.
- Speaker #0
So it's not just about rational economic factors. Our own human quirks might be playing a role in shaping these market patterns.
- Speaker #1
Exactly.
- Speaker #0
That's a fascinating thought.
- Speaker #1
Yeah, it is. And it highlights the fact that the market isn't always a perfectly rational machine. Right. There are human emotions and psychological factors at play. that can influence how prices move.
- Speaker #0
OK. So we've got some intriguing theories, but no definitive answers. Right. But here's what I'm really curious about. OK. Can we actually use this knowledge of the turn of the month effect to our advantage? Yeah. Can we turn this market anomaly into a profitable trading strategy?
- Speaker #1
That's the question every algo trader is asking, right? Yeah. And the research does suggest some possible approaches.
- Speaker #0
All right. Let's get into the nuts and bolts of it. OK. What kind of trading strategies have researchers explored based on this turn-of-the-month effect?
- Speaker #1
One of the most straightforward strategies involves the SPY ETF, which tracks the S&P 500 index. The strategy is simple. Buy the SPY ETF one day, or even four days before the end of the month, and then sell it on the third trading day of the new month at the close.
- Speaker #0
Okay, so it's a very short-term tactical trade, capitalizing on this potential surge in prices. around the turn of the month. Yeah. Has anyone actually backtested this strategy to see if it holds up in the real world?
- Speaker #1
You bet they have. Okay. And the results are pretty compelling. Multiple studies, including Hsu and McConnell's paper, have shown that this simple strategy has historically outperformed a buy and hold approach, meaning you would have make more money by timing your trades around the turn of the month than by simply holding the SPY ETF continuously.
- Speaker #0
Wow. That's impressive.
- Speaker #1
Yeah.
- Speaker #0
But I know we always have to be cautious about relying on back-tested results. Right. Past performance is no guarantee of future returns, right?
- Speaker #1
Absolutely. It's crucial to remember that markets are constantly evolving. Yeah. And what worked in the past might not necessarily work in the future. Right. There's always a risk that this turn-of-the-month effect could weaken or even disappear as more and more traders try to exploit it.
- Speaker #0
So it's not a foolproof, set-it-and-forget-it strategy. Right. Got it. Are there any other caveats or warnings researchers have highlighted about this strategy?
- Speaker #1
Well, one thing to keep in mind is that these calendar effects can be a bit like a game of whack-a-mole. Okay. Sometimes they seem to vanish or even shift to different days in the month as the market adapts to the strategies being used.
- Speaker #0
Ah, so it's not a static phenomenon. Right. We need to stay vigilant and adapt our approach as the market changes. But even with those caveats, this turn-of-the-month effect is a fascinating example of how The market isn't always perfectly rational. Yeah. There might be some predictable patterns out there waiting to be discovered.
- Speaker #1
Absolutely.
- Speaker #0
And perhaps exploited by savvy investors.
- Speaker #1
Precisely. And it highlights the importance of constantly analyzing market data, looking for those hidden edges that can give us an advantage.
- Speaker #0
Okay. So we've talked about a specific trading strategy based on the SPY ETF. But I'm curious if this turn of the month effect shows up in other markets or asset classes as well. Yeah. Did the researchers explore this at all?
- Speaker #1
They did. And what they found is that this isn't just a U.S. phenomenon. They analyzed data from 34 different countries around the world. And guess what? I don't know. A turn of the month effect was present in 30 of them.
- Speaker #0
Wow. So this isn't just some quirk of the American stock market. Right. It seems like there's something more fundamental at play here. Something that transcends national borders and market structures. Yeah. Does that make it easier or harder to explain?
- Speaker #1
Well, it certainly adds another layer of complexity. Right. If it were only a U.S. thing, we could focus on potential explanations related to specific regulations, market structure, or even cultural quirks. Yeah. But the fact that it's so widespread globally suggests there might be some deeper, more universal driver we haven't identified yet.
- Speaker #0
So we've got a global mystery on our hands.
- Speaker #1
That's right.
- Speaker #0
But that's what makes this so exciting, right? The pursuit of knowledge.
- Speaker #1
It is.
- Speaker #0
The thrill of the unknown.
- Speaker #1
Absolutely. And even if we never fully understand the why behind this effect, the fact that it exists and has persisted for so long is valuable information in itself. It tells us that markets aren't always perfectly efficient and there might be opportunities to generate alpha by simply paying attention to the calendar.
- Speaker #0
All right. So let's wrap things up by bringing this back to our listeners. Sure. What are the key takeaways from this deep dive into the turn of the month effect? What should our listeners be thinking about as they go about their own trading or investing?
- Speaker #1
I think the most important takeaway is that there's still so much we don't know about the markets. Yeah. This turn of the month effect is just one of many anomalies that challenge our traditional understanding of finance. Right. It's a reminder to stay curious. Yeah. Keep questioning assumptions and never stop exploring. exploring new ideas.
- Speaker #0
That's a great point. It's easy to get caught up in the day-to-day grind of the market.
- Speaker #1
Yeah.
- Speaker #0
But it's crucial to keep that sense of wonder and curiosity alive.
- Speaker #1
Exactly. And remember, knowledge is power, especially in the world of finance. The more you understand about these market quirks, the better equipped you'll be to make informed decisions and potentially improve your returns.
- Speaker #0
So listeners, if you're looking to add an extra edge to your trading strategies, don't discount the power of simple calendar effects. This turn of the month anomaly is a great example of how seemingly random market movements might actually have some rhyme and reason to them.
- Speaker #1
And it's a reminder that even in today's world of high frequency trading and sophisticated algorithms, there's still room for the individual investor to gain an edge by understanding these market patterns.
- Speaker #0
Thank you for tuning in to Papers with Bekde's podcast. Thank you. We hope today's episode gave you useful insights. Of course. Join us next time as we break down more research. That's good. And for more papers and backtests, find us at https.paperswithbacktests.com. Great. Happy trading.
