A Big Change in Seasonality Coming Right Up

Posted by Don Vialoux - Timing the Market

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‘Sell in May and go away’ may not pay off this year: Use VIX options, futures and ETFs to hedge against declines

It’s that time of year again when investors look to the seasonal strategy of “Sell in May and Go Away” leading to the liquidation of market positions following the many months of gains. The strategy implies that investors should own Canadian and U.S. equities during a period of seasonal strength from the end of September to the end of April and avoid equities during a period of seasonal weakness from the beginning of May to the end of September.

This year however investors may want to ride out the summer, albeit with a bit of hedging for safety.

Outside of their average period of seasonal strength from October 28th to May 5th, North American equity indices have a history of mixed returns between May 6th and October 27th. The S&P 500 Index lost an average of 0.42 percent per period over the past 20 years from May 6th to October 27th, compared with an average gain per period of 8.82 percent during the favourable October to May period. Results are more pronounced for the S&P/TSX Composite Index. The Index lost an average of 1.09 percent per period from May to October over the past 20 years while gaining an average of 10.03 percent per period during the favourable timeframe. Performance by equity markets during the summer months tends to be random due to a lack of significant annual recurring events that favourably influence equity markets.

The strategy to take profits around May 5th worked on queue last year. Investors that exited market positions on May 3rd last year avoided a 15 percent drop by the S&P 500 Index over the course of two months. These investors also sidestepped the Flash Crash on May 6th when the Dow Jones Industrial Average plunged 900 points.

Valuation models suggest that the S&P 500 Index currently is fairly valued. Prior to entering the first quarter earnings season, the S&P 500 Index was trading at 18 times trailing earnings. However, strong consensus earnings growth estimates for 2011 imply that the S&P 500 Index is trading at only 13 times earnings for the current year. The average multiple for the S&P 500 Index over history has been around 16. Moreover, recent earnings beats and increased guidance suggests further revisions to growth expectations over the next 12-months.

Cyclical influences also may give reason for optimism through the current May to October timeframe. The pre-election year of the Presidential Election cycle typically extends positive returns for equity indices through to the third quarter of the year. Gains between May 5th and October 7th for the years preceding the Presidential election have averaged 4.3 percent over the last 60 years. The historic reason for optimism is efforts by the President to become more accommodative in policy-making in order to increase chances of his re-election or election of his party’s candidate. It remains to be seen whether President Obama will take this strategy in 2011.

North American equity markets currently have a positive technical profile. Recently, indices rebounded from oversold levels reached in mid- April. Last week, the Dow Jones Industrial Average closed at a 33 month high. The S&P 500 Index is testing highs charted in February. A breakout to new highs implies upside potential of 4 percent to 5 percent this summer.

Timing for the “Sell in May and Go Away” strategy varies slightly each year and are fine tuned using technical analysis. For now, risk reward parameters for equity market exposure remains favourable. Investors concerned about a possible correction in equity markets in the May 6th to October 27th period can apply hedges to protect against downside risks. Hedge strategies include gaining exposure to the volatility index (VIX) via options, futures or ETFs, accumulating positions inversely correlated to broad market indices, and taking advantage of put option safety-lines for positions most at risk of declines.

Jon and Don Vialoux are authors of a free daily report on equity markets, sectors, commodities and Exchange Traded Funds. Reports are available at www.timingthemarket.ca and www.equityclock.com. Follow us on Twitter:@EquityClock

Tech Talk and EquityClock.com Seasonality Column in the Financial Post (Published yesterday at http://business.financialpost.com/2011/04/26/stay-in-may-this-year/