BEING STREET SMART

by Sy Harding 

Will Seasonality Overcome the Economic Uncertainties? October 14, 2011.

Most investors, even famed hedge fund managers, have experienced a rough year so far (unless they had downside positioning to take advantage of the summer correction). At its low two weeks ago the S&P 500 was down 20% from its April 29 peak, on the edge of crossing the threshold into a bear market. Even with the rally of the last two weeks it’s still down 12% from that peak.

And significant uncertainties continue to obscure the outlook.

The European debt and banking crisis remains in limbo, with experts warning Europe must quickly rescue the situation to prevent a global recession. Against that backdrop, the latest economic reports show economic growth in Europe continues to deteriorate, along with business and consumer confidence.

In the U.S., the minutes of the Federal Reserve’s last FOMC meeting, released this week, revealed there are concerns even within the Fed that it may be too optimistic in expecting the economic slowdown will reverse by year-end. And business and consumer confidence in the U.S. continues to slide. On Friday we got the first look at conditions in October. The University of Michigan reported its closely watched Consumer Sentiment Index fell further in the first half of this month, to 57.5, from the already troublesome 59.4 in September.

However, there is potential good news. We’re approaching the market’s favorable season. Can its positive influence overcome the economic uncertainties and produce a typically strong stock market in the winter months?

Twice a year, in the spring and fall, I remind you of the strong historical tendency for the stock market to make most of its gains between November and May each year, and experience most of its losses in the opposite period.

You don’t have to take my word for it. Academic studies provide clear evidence.

For instance, a 27 page-study published in the prestigious American Economic Review in 2002 concludes “We found that this inherited wisdom of ‘Sell in May and Go Away’ to be true in 36 of 37 developed and emerging markets.” It went on to say that, “A trading strategy based on this anomaly would be highly profitable in many countries. The annual risk-adjusted outperformance ranges between 1.5% and 8.9% annually [above the market’s performance] depending on the country being considered. The effect is robust over time, economically significant, unlikely to be caused by data-mining, and is not related to taking excessive risk.”

 Another study in 2008 at the New Zealand Institute of Advanced Study, which focused solely on the U.S. market, concluded that, “All U.S. stock market sectors, and 48 out of 49 U.S. industry sectors, performed better during the winter months than summer months in our sampling from 1926-2006.”

Does it work in every individual year?

No. But then no investment strategy does. For instance, seasonality under-performed the market in 2003 and 2009. In those years the market made gains in the winter months and then, fueled by massive government stimulus programs, continued to make gains during the summer months when a seasonal investor would have been out of the market.

However, the seasonal investor doesn’t necessarily lose money in such years, but only misses out on further gains in the summer months. But when investors are in the market during the unfavorable seasons and the market declines, their give-back of previous gains can be substantial, and it can take months or years just to get back to even.

The traditional seasonality maxim, ‘Sell in May and Go Away’, calls for entering the market on November 1 and exiting on May 1 of the following year. Those dates were the basis for the academic studies mentioned above.

But obviously the market does not begin a big rally on the same day each fall, or roll over into a correction on the same day each spring.

So my newsletter’s Seasonal Timing Strategy™ uses a technical indicator that tracks market momentum reversals to better identify the entries and exits. By its method entry signals have been as early as October 16 and as late as early December, while the exits have been as early as April 20 and as late as late June.

The modification significantly improved the already impressive performance of the basic ‘Sell in May and Go Away” seasonal strategy.

The question at this point, with favorable seasonality potentially approaching by either method, is will it help overcome the uncertainties and produce a typical strong market in the winter months.

For those who believe this time is different and the negatives are too serious, it might pay to recall 2001. In the fall of 2001, the 2000-2002 bear market was underway, in fact only half over. The S&P 500 was already down 28%. Then the 911 terrorist attacks took place. The stock market was closed for a week, and when it re-opened the market plunged further. Fear was high that more attacks would follow. Troops were guarding government buildings around the country. People were hunkered down in their homes, fearful of venturing out to malls or restaurants where crowds might be targets for terrorists attacks. It was widely expected the 2001 recession would plunge further into another Great Depression, and the Dow would collapse to 1,000.

But that low was the beginning of a bear market rally through the favorable season that had the S&P 500 up 21% by March 19, 2002.

And so it has been for decades. No guarantees, but the winter months tend to be positive regardless of surrounding conditions.

In the interest of full disclosure, followers of my Seasonal Timing Strategy are currently 100% in cash, at least for the moment, after exiting last April 20 for the unfavorable season (at which time a profit of 15.2% was taken from last winter’s favorable season, and was not given back in this summer’s correction).    

 

Sy Harding is president of Asset Management Research Corp, and editor of www.StreetSmartReport.com, and the free market blog, www.streetsmartpost.com.

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