Sell in May? A Follow-up

At the beginning of May, I wrote a post questioning the validity of the old trader's axiom of Sell in May. Although it's a widely-held truism, the previous 29 years of market action in May reveal the exact opposite to be true.

With May 2009 in the books, the contradiction has extended itself.

The NASDAQ has now closed higher in May a remarkable 20 out of the past 30 years -- a 66% occurrence rate since 1980. The SPX has done even better, with a positive close in 21 of the past 30 May cycles (70%).

The streak has strengthened in recent years. Since the 2002 bottom, the NASDAQ has climbed in May six of the past seven years. The gains are statistically significant as well. Since 1980, the average May for the NASDAQ is +1.87%; for the SPX it's +1.51%.

However, despite this track record, predictions of May weakness are trotted out each year as part of the established canon of trader wisdom.

Why the discrepancy?

Perhaps the biggest reason is that Sell in May is the opening gambit in a longer seasonal trading strategy known as the Halloween Indicator. Part of trader lore for generations, in July 2001, Sven Bouman and Ben Jacobsen examined the financial markets of 37 countries, some as far back as 1694. They established that, across three centuries and multiple economies, winter has produced better market results than summer.  So, for 300 years, selling in May and buying back in after Halloween has produced better returns.
 
The point here is that for 30 years dumping stocks in May has reduced these seasonal returns, and it's a fact inexplicably unnoticed by trading mavens, the mainstream press and the blogosphere alike. For example, in Oct 2007 Mark Hulbert -- normally excellent with these types of observations -- considered ways of improving the Halloween Indicator. However, Hulbert focused on MACD confirmations and never mentioned May performance. This year, Hulbert insisted that the Halloween Indicator remains strong, while again neglecting the May anomaly. It will be interesting to see when the investing community finally recognizes that Sell in June is the better rule of thumb.

It's important to understand that, by their own admission, Bouman and Jacobsen could never establish why financial markets outperform in winter. Looking ahead, it's possible that globalization and the 24/7 interconnection of world economies could impact this centuries-old market pattern to an even greater degree.

As I write, the profitable winter season is just three weeks away  -- in Brazil, Australia, Indonesia, South Africa and every other market south of the equator.

Time to sell?

Sell in May?

Is May really a good time to sell?

I looked at the past twenty-nine May trading periods on the NASDAQ -- from May 1980 to May 2008. Surprisingly, the NASDAQ closed higher during the month of May a very respectable 19 out 29 times -- a 66% occurrence rate.

Even more interesting, since the Dotcom bottom, the occurrence rate of a positive May close accelerated to 83%. The NASDAQ has posted gains in five of the past six May trading periods.

The result is that in the 29-year sample, the average NASDAQ performance in May was actually a gain of 1.82%.

So much for old wives' tales.

It's worth noting that, up or down, the average moves were statistically significant as well. During the years that the index moved up in May, the average gain was 4.99%. During the years the NASDAQ fell, the average May loss was -4.21%.

The SPX produced similar results. Since 1980, the SPX closed higher in May 20 out of 29 times -- one year better than the NASDAQ! The average SPX performance in May for the past 29 years has been a respectable gain of 1.38%.

The bottom line is that, on average, the market moves higher during most May trading periods. When it does, the moves tend to be a big ones as well. When the market moves lower in May, it's usually a hefty tumble.

Will the stock market close higher in May 2009? It's impossible to know, but a seasonal wives' tale isn't the place to look for answers.

Investing is so complex that there is a natural tendency to try and simplify the process. The problem with simplification is that, by its very nature, it distorts the data. In the case of salty trading yarns, this distortion can produce completely erroneous interpretations.

So maybe it's Sell in June?

The most reliable advice is probably the most useful epithet of them all:

Trade what you see, not what you think.

Good luck trading.

best

dk

NASDAQ Historical Performance in May
May 1980 -- 7.47%
May 1981 -- 3.11%
May 1982 -- (3.34%)
May 1983 -- 5.35
May 1984 -- (5.91%)
May 1985 -- 3.65%
May 1986 -- 4.41%
May 1987 -- (0.30%)
May 1988 -- (2.34%)
May 1989 -- 4.36%
May 1990 -- 9.26%
May 1991 -- 4.41%
May 1992 -- 1.15%
May 1993 -- 5.91%
May 1994 -- 0.18%
May 1995 -- 2.44%
May 1996 -- 4.44%
May 1997 -- 11.07%
May 1998 -- (4.80%)
May 1999 -- (2.84%)
May 2000 -- (11.91%)
May 2001 -- (0.27%)
May 2002 -- (4.30%)
May 2003 -- 8.99%
May 2004 -- 3.46%
May 2005 -- 7.63%
May 2006 -- (6.19%)
May 2007 -- 3.15%
May 2008 -- 4.55%

29-year avg = +1.82%

Long-term Potential

Because of an epic workload, this is my first post since August 5, 2008.

Watching eight months of historic market action often from a hotel room 16 time zones away has been an unforgettable experience. Water was boiling in pots I could not always see, and in hindsight this produced a more balanced market perspective than I would have gained otherwise.

Thanks to everyone for the e-mails and PMs along the way. All were much appreciated. Even though my schedule is actually more complicated now than it was last summer, recent market developments are worth a few comments.

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Regardless of what the financial news, economic data, political headlines, monetary policy, pundits, bloggers, message boards, co-workers or even your own common sense is telling you, the market itself is saying that an important, long-term bottom is in.

Of course, the spectacular, short-term shenanigans in the market will continue. The global economy has serious problems, and these are complicated by a lack of consensus surrounding both patient and cure. Investors shouldn't expect a smooth ride anytime soon.

Despite the bumpiness, an increasing number of technical indicators suggest that the March 2009 bottom is an event with lasting value. These data imply that the rally – with all its imperfections – will ultimately have legs. A good way to monitor this idea is during periods of market indecisiveness. If the bias of the market has truly changed, low-volume, enigmatic market pauses will resolve upward, instead of lower as they have for the past 18 months.

However, this post concerns more long-term signals, and below are observations on eight of the more noteworthy. When considered together, these indicators provide perspective on a beleaguered market and its longer-term potential. What these indicators say is that for investors with extended time horizons, the conditions are ripe to start applying capital.


1. The Cyclical Bear Market Continues…
It’s wise to start with a word of caution. Historically, until the blue line on the chart below crosses back above the red line, stock ownership is marked by heartbreak and remorse. That said, the black line below is also printing massive positive divergence. When the stock market finally catches up with this divergence, the momentum is likely to be significant.





2. VIX
One of the great side stories of this recession is how Robert Whaley’s obscure volatility indicator was catapulted into investing superstardom. Fueled by a populist obsession with “fear”, the VIX’s ascent was matched only by the chronic misunderstandings surrounding its meaning. As always, for maximum clarity, read Bill Luby's Vix and More and Adam Warner's Daily Options Report. Both offer hyper-informed takes on market volatility and all its implications.

The weekly chart below shows that the VIX is printing signs of a pending decline. Rather than “causing the market to go up”, a bearish VIX simply indicates that options strategies are shifting as institutional investors warm to the idea of increased long exposure.





3. Bonds
After a 9-week climax run from Oct-Dec 2008, it appears that the historic bull market in long-dated Treasuries may finally be over. Bill Gross has been anticipating this topping event since June 2007, and laid odds it would happen before 2010. It appears he nailed it.

The weekly chart below is bearish for bonds, as institutional investors have begun the long fade out of government debt and into other investments offering better returns. Historically, this redeployment is into equities and corporate debt.





4. NASDAQ High-Low Indicator
While not great at picking tops, the NASDAQ High-Low chart is remarkably effective at picking major bottoms. After big, sub-20 dips, crossovers by the 10-week EMA back above 35 marked key bottoms in both 1998 and 2002. After spending 18 months below, the High-Low is finally ready to cross back above 35. This 18-month submersion marks the longest the High-Low indicator has been under 35 in its 20-year history. It’s one of several market signs that sellers have grown exhausted.





5. Tech Ratio
Another indicator pointing to seller exhaustion is the Tech Ratio. This metric compares an index of 220 pure technology stocks with the overall NASDAQ. The chart below shows that even though the NASDAQ bottomed in 2002, investors continued to loathe tech stocks long afterwards. In the summer of 2006 -- ironically as the Dow was printing new all-time highs -- the scorned Tech Ratio finally hit bottom (red circle).

But fortunes have changed. As the market imploded in late 2008, many tech stocks avoided the intense declines. As a result, over the past seven months tech has actually outperformed the indexes, and in April 2009 the Tech Ratio broke to a new 6-year high. Technology in a sustained leadership role hasn't happened in 10 years, and this is a welcome positive for the market.





6. NDX/SPX Ratio
Another important metric of market-health-through-tech-leadership is the performance of the Nasdaq-100 vs. the S&P500. Historically, the market has always done better when the NDX outpaces the SPX. Like the Tech Ratio, in April 2009 the NDX/SPX Ratio broke to an 8-year high.





7. Emerging Market Ratio
Like the rest of the world, emerging markets suffered withering declines in 2008. However, the slumdogs have since mounted an impressive comeback. The Emerging Market Ratio compares emerging markets with all overseas markets (Europe, Australia and Asia). Like the Tech and NDX/SPX Ratios, in April 2009 Emerging Market Ratio ratio also broke to a new all-time high. Investor appetite for the riskiest global assets is yet another encouraging sign.





8. Contrarian Indicators
Finally, there are the current extremes in negative investor sentiment. The Investors Intelligence Bull/Bear Ratio is near a 5-year low. However, the most interesting feature of this chart is how unfazed it was by the recent 26% rally. The bulls simply don’t believe it, which is exactly what you want investors to feel after a 26% run-up, especially 18 months into a bear market.





Below is a 30-year view of the Michigan Consumer Sentiment Survey. It’s been 29 years since this survey has recorded sentiment so negative. While the reality of this is unfortunate, it is from such despair that the most durable bottoms are born.






These observations provide little insight into short-term market direction. For that, I encourage you to bookmark The dk Report Charts. I keep this chart library current with short-term annotations, even when I'm 16 time zones away.

Soon enough, the current rally will end in an ugly 10-15% correction, probably at the moment of maximum inconvenience. Based on broader plate tectonics, this should be a constructive event, and the odds favor the March lows holding.

Thanks for reading, and best of luck with your trades. I look forward to posting again when I can.

Until then,

best

dk