Every year at this time there are usually a few articles that tackle the “Sell in May and Go Away” conundrum and try to establish if it is prudent to reduce equities at this time. This year there seems to be more articles on the subject than usual. After a good run in the markets investors are wondering if they are about to be burnt once again. I have been writing about the Favorable- Unfavorable Six Month Strategy for over a decade. In 1999, a book by Bruce Lindsay and Brooke Thackray, “Time In Time Out, Outsmart the Stock Market with Calendar Investment Strategies.”  This book is by far the most comprehensive book written on the six month market cycle.  The authors examined the cycle by decades, using different indexes and including dividends and interest payments. I can tell you that almost all of the articles written on the subject only scratch the surface of the issues and provide an incomplete analysis.

From my analysis, the best time to be “in the broad market,” such as the S&P 500, is typically the six month period from October 28th to May 5th. Over the long-term, from 1950 to 2008, this favorable six month period has produced an average compounded gain of 7.6% in the S&P 500. The remaining six month period, the unfavorable season, from May 6th to October 27th, has produced an average compounded gain of -0.2%. The Unfavorable vs. Favorable Six Months table illustrates a year by year result from 1950. It does not include the results of 2008/2009 as we are not officially finished the cycle. If the results were added the numbers for the unfavorable season would be much worse, as the S&P 500 turned in a negative 40% performance.

The time period for my six month strategy differs from every other writer on the subject. The standard analysis looks at the period from November 1st to April 30th. The reason is that full month returns have been used for market analysis since stocks started to trade over one hundred years ago. In other words, it is just habit. I start the favorable six month cycle a few days before the beginning of November because on average from 1950 to 2007 the last few days of October have produced an extra 1% return. This year, buying at the end of day on October 27th produced an extra gain of 14% before November started. Similarly, selling a few days into May (May 5th) has produced an average extra ½% gain compared with selling at the end of April. Why give up the extra returns? If more writers used my dates in their analysis a lot more investors would see the benefits of paying attention to the six month cycle of the market.

Unfavorable vs. Favorable 6 Months

From a compounded gains return perspective over the long-term, the difference in returns between favorable and unfavorable periods has been huge. If an investor had started with $10,000 in 1950 and only invested in the favorable six month period up until 2008, they would have profited $806,204. On the other hand, if an investor had only invested in the unfavorable six month period they would have made a profit of -$535. This is a huge difference in compounded returns. Investors have to ask whether it is worth being in the markets during the six month unfavorable season with an expectation of a small profit and whether they are being fully compensated on a risk-reward relationship.

In order to fully analyze the risk reward relationship it is important to go beyond the average return numbers and examines the probability and size of returns. Aside from the favorable time period producing a much higher arithmetic average gain, it has also produced a much higher frequency of market returns greater than 5% and 10%. In addition the frequency of large losses at the 5% and 10% levels is dramatically less. Overall, the time period from the end of October to the beginning of May tends to produce bigger gains more frequently and suffer fewer losses than the time period from the beginning of May to the end of October.

Before finishing up the justification to reduce equities at this time of year, the market tends to either peak at the beginning of May or mid-July. The mid-July peak tends to occur when the market is in a major bull market with lots of momentum and positive sentiment. Although the market has had a great April, it is difficult to argue that we are in a strong bull market at this time. I often get asked the question if this time is different and if the markets will have a strong summer rally? First, I must state that seasonal analysis looks at historical trends and does not guarantee that events will occur in the future. In other words, it is possible for a large increase in the market during the unfavorable six months. In the past, large summer rallies have been rare and are usually accounted for by the mid-July peak.

Strong rallies that have occurred during the unfavorable season are typically “v shaped” and occur after a nasty bear market when the economic outlook or earnings expectations makes a dramatic shift during the summer. Despite the recent strong rally in a nasty bear market, at this time I am not willing to bet that the economic or earnings numbers will change dramatically over the next few months.

Not only is this a time to reduce equities, but to also refine investment selections to more conservative holdings. During times of expected pullbacks or periods of little return, generally it is best to seek quality stocks or exchange traded funds. If a certain percentage of the portfolio is to be allocated to a sector that typically does not do well during the summer months, choose more conservative holdings with lower betas. You still get to participate in the sector, but will not be hit as hard if there is a downturn in the market.

All is not lost for investors during the unfavorable six months as opportunities for profits exist by replacing investments that are in sectors that perform poorly during the summer months with ones that typically outperform. As a quick mention; the defensive sectors tend to outperform, biotech, gold, oil and other sectors all have their time. There are also two good holiday trades for the broad market: the Memorial Day Trade and Independence Day Trade.

Overall the market has had a good run since the March 9th closing low of 677 for the S&P 500. I have been silently praying that we at least make it back to the October 27th level of 849. Over the last few weeks we have been consolidating slightly above and below this level. At the time of writing this document the S&P 500 sits at 878.

If the market breaks down during the summer months, a key support level to watch is the November 20 closing low of 752 as this support line is close to the long-term support in October of 2002.  A breakdown at this point will indicate significant weakness in the market and market will try to consolidate between 752 and 677, the March 9th closing low.

The March 9th closing low is very significant. Most investors and analysts are expecting this to be the bear market low. If this level is breached on significant volume, expect the market to do poorly over the short-term and higher volatility to return to the market as it is possible that some investors may start to panic.

At the current time there are signs that the market has some legs as we have just finished an incredible April, up 9.4%.  In addition the VIX has been declining and technology stocks have been outperforming, which is positive for the market in the short-term.

These positive indicators may give investors some room to reduce equities, but they do not ensure that the rally will last forever.  Investors should be using this opportunity to readjust portfolios, take profits (or decreasing equity positions) and prepare to rotate into sectors that are expected to outperform in the summer months.