Sell in May and Go Away?
Stocks have had a pretty strong start to the year. After a tiny bit of February turmoil, U.S. equities have posted solid gains through the bulk of May. While the S&P 500 is only up around 1.4% on the year, the NASDAQ and Russell 2000 have gained 6.50% and 6.32%, respectively.
For decades, many stock investors have followed the advice of "sell in May and go away". In other words, take your money and run before the summertime. According to the advice, stock returns in the first five months of the year are typically better than they are in the last seven, due to a number of cyclical factors. Businesses & corporate earnings tend to slow down in the summertime, as do trading volumes and general "money making" activity. So by purchasing stocks in late December & early January, then selling them all in May, you can capture better returns than if you were fully invested throughout the 12 month period. (And presumably take advantage of the January effect, too).
So since we've had a nice start to the year, should you be selling your equities now? Does this strategy actually work? If you’re familiar with me, the firm, or our investment philosophy, you probably know that everything we do for our clients is based on empirical evidence. We don’t manage money based on gut instinct, speculation, or prognostication. Our process is methodical, consistent, and based on the research.
That means that in order for me to recommend selling in May & going away, there'd have to be definitive statistical evidence and logic backing it up.
Like many investing cliches, "Sell in May & go away" actually has some truth behind it. There are three predominant studies examining the strategy that I know of. Here's a quick summary of them:
This study examined seasonality of stock market returns in 37 different countries, as far back into history as the researchers could find data for. In the UK they actually had enough historical data to go back to the late 1600s. The paper concluded that seasonality did exist between November and April, in 36 of the 37 countries examined. Additionally, they found that the effect was strongest in Europe.
This study didn't go as far back as Bouman & Jacobsen. Here the researchers tested the strategy between April of 1982 and April of 2003. They also excluded two months of data during market crashes: October of 1987 and August of 1998. Note that both these periods happen to be during the "go away" period, when you wouldn't have anything at risk if you followed the strategy. Their conclusion was that the strategy did not work well between 1982 & 2003, or during any of the periods surrounding the market crashes:
- April 1982 - September 1987
- November 1987 - July 1998
- September 1998 - April 2003
This study was performed as a follow up to Maberly & Pierce's in 2003. Here, the researchers used the time period of 1998 - 2012, and concluded that the effect existed in all 37 markets they studied. On top of this, the difference between seasonal returns in November - April and May - October is about 10%! Holy smokes!
So what should we do? We have three papers studying the topic. One that concludes sell in May & go away doesn't work, and two that do - with one claiming that returns are even 10% better between November and April.
Before jumping to the conclusion that we need to bail on our equity positions before it's too late, we need to consider another important factor: taxes. By heeding the strategy, buying in November, then turning around & selling in April, you'd only have held equity positions for 6 months or so. Remember that from a capital gain standpoint, long term capital gains rates kick in when you hold a position for longer than 365 days. By holding equities for only 6 months, higher, short term capital gains rates apply:
So, if you're a six figure earner and find yourself in the 24% or 32% tax bracket or higher, you'd only be on the hook capital gains taxes of 15% or 20% by holding positions at least a year. This can end up being quite a savings.
Given the tax impact of selling in May and going away, and the varying opinions on the research side, I'm not ready to adopt the strategy yet. But before we dismiss it entirely, let's catch up on what's happening across the capital markets.
The Bear Case: Reasons to be Pessimistic
There are a few reasons to be pessimistic about the next few months & quarters in the markets. First, it’s a midterm election year. Election years have historically been volatile, with greater swings and larger maximum drawdowns. On top of this we have continued uncertainty politically, with President Trump wavering on the upcoming summit with North Korea. Plus, trading volume is typically lower in the summertime, as people take off on vacation. Lower volume can mean less support on the downside, leading to harsher drops when the news does go sour.
Internationally, Italian bonds had a recent scare as the prospect of leaving the Euro gained momentum. Italy has several upcoming elections, and bondholders are somewhat fearful that they could turn into a referendum for departure. This caused a brief, albeit sizable, sell off on Italian government notes.
Remember that bond prices react inversely to yields. When news about potentially damaging policy comes out, investors tend to demand a higher return on their investment as compensation for the additional risk involved (see the image above). This causes prices to fall.
In my opinion the chances of Italy actually leaving the Euro are quite low. As frustrated as the country may be, Britain's exit should provide some guidance. Now that the UK is on the outside looking it, it's economy is less integrated and international trade is beginning to suffer. Italy should not want to find itself in the same situation, as by most measures its economy is not quite as strong.
The Bull Case: U.S. Economy
The bull case mostly centers on the strength of our economy here in the U.S.. According to the National Bureau of Economic Research, our current economic expansion is now 106 months old. This makes the current cycle the second longest expansion in the last 100 years, with the average length being only 58 months!
The longest expansion on record occurred between November of 2001 and December of 2007. I don’t need to tell you that this was during the “good portion” of the real estate bubble. Home prices rose steadily, construction boomed, and low interest rates & loose lending standards allowed consumers to borrow well beyond their means.
Interestingly, the other long expansion you’ll notice on the chart occurred between February of 1961 and December of 1969. This was during the Vietnam War. The federal government adopted a highly expansive fiscal policy during this time frame. I’d be surprised if this was used as a means to stoke the economy though. I'm not a historian, but my instinct tells me that Lyndon Johnson & JFK were more interested in financing the war, with the economic expansion being a convenient byproduct.
We should expect the current expansion to change course just because it's a little long in the tooth, either. Economies don’t expand & contract based on predetermined times. Economic cycles depend on fiscal and monetary policies, inflation, and other factors, and the data right now is strong. The most recent read on inflation was in March, and registered slightly south of the Federal Reserve’s long term target of 2% per year. This is healthy. We definitely don't want inflation to run out of control, forcing the Federal Reserve to spike interest rates and stall economic growth. But at the same time we don't want 0% or deflation (negative inflation), which cause other problems. 2% is a very healthy number.
Additionally, GDP growth is strong. Partially due to President Trump's recent tax cuts, large corporations are reinvesting a great deal back into their companies and have posted strong gains in several consecutive quarters.
Before concluding this post, I want to touch on crude oil since it’s been in the news recently. Crude oil has been on a steady upward run over the last several years. As I write this, WTI Crude Oil currently trades at $68.12, per barrel, compared to $49.63 just one year ago. Over the last week or so there’s been some concern that both OPEC and non-OPEC countries might list their output curbs that have been helping boost prices. Typically OPEC countries prefer to reduce the amount of oil they pull out of the ground, in order to maintain robust prices. Many of the middle east OPEC members, including Saudi Arabia (the largest & most influential member) depend heavily on oil revenues. By constricting the supply of oil being brought to market they're able to stabilize price and boost their own revenues.
As you may have read, oil prices fell substantially recently, from $72.26 per barrel on May 21st to $66.80 by May 28th. The backstory here is that it’s likely Venezuela and Iran will be reducing oil production in the near future. Venezuela’s economy is currently in a downward spiral, and Iran is again subject to harsh U.S. sanctions after we backed out of the nuclear agreement. Saudi Arabia and Russia have discussed the idea of decreasing their production cuts and bringing more oil to the market in response. While Saudi Arabia & Russia could replace the lost production from Venezuela & Iran, reports suggested that the likelier scenario would actually add a significant amount of oil to the market. And as you know, when supply goes up market prices fall.
As I hinted at, oil prices bounced back swiftly on the 30th. Reports surfaced that OPEC and non-OPEC countries (Russia) plan to continue production curbs at least through the end of the year. So while we’ll probably see a brief dip in gas prices at the pump, don’t expect the trend to continue throughout the summer season. Oil prices are already back on the rise, meaning gas prices will follow shortly.
The Big Picture
To sum it all up, we have several reasons to be skeptical about the state of the markets. We have a run up in stocks to start the year, we're approaching the cyclical summer slowdown, and Italy is experiencing some volatility with their sovereign bonds.
But with all that in mind, the research is conflicted surrounding the "Sell in May" strategy. And without definitive evidence that such a strategy will do less harm than good, I'm inclined to stick to the fundamentals of investing. Plus, there are adverse tax consequences of doing so and our economy is on solid footing.
Remember: the path to the best investment outcome is a long term and consistent strategy, not one where we sell stocks after a nice bull run. So no, please don’t sell in May and go away. Stay invested with a consistent, long term strategy.