Sell in May and Go Away? Yes.

Once April rolls around, the seasonal effect of selling-in-May-and-going-away makes its comeback in media. Should an investor follow this adage? Let me break it down. The original academic article written by colleagues of mine, Bouman and Jacobsen (2002), called the seasons effect "The Halloween Indicator."

Their research concludes that for a U.S. portfolio the return between a portfolio that is invested during the summer and a portfolio not invested during earn a very similar return over a long period. However, the portfolio that raised cash during the summer had lower volatility. This research does not take into account the affect of taxes or trading costs. It appears for the average investor it does not make sense to sell in May and try to time a re-entry point. Then you must pay transaction costs, can not defray capital gain taxes, and emotional biases may set in where you buy in at the wrong time or sell and regret it.

I have recently been working on an academic paper that examines this seasonal effect at a deeper level. I have been looking the seasonal effect during different economic environments. For example, during May to August of 2009 the United States was in the midst of a rebound from depressed stock levels. The same for the summer of 2003. Those periods were horrible time to sell in May and go away. However, other periods such as 2004 sell in May and go away worked. I find that investing based on this seasonal effect works only in certain economic environments. If one can identify those environments than one can successfully sell in May and go away.

What cycle or environment are we in now? Based on the Behavioral Finance Investment Advisors (BFIA), we have detected three periods in the past forty years that are similar to today. One of those periods is 2004. Let us take a look at 2004. From the beginning of January to the 3rd week in April the S&P 500 increased over 4%. From the end of April to the beginning of August it fell over 4% and from August to December is increased around 13%. From the beginning of January to April 15th, 2011 the &P 500 is up around 5% similar to the first quarter of 2004.

So far our indicators since November of 2010 have been tracking the 2003-2004 indicators very closely. Take a look at the chart below which plots our indicators for the January - April period for 2004 and 2011.

Figure 1: BFIA Indicators 2004 vs. 2011

It can been seen that they are tracking each other very closely.

The conclusion here is that it is important to identify the investment cycle that we are currently in and then decide whether the seasonal effect applies. Forget all the other noise in the market. Where we are in the cycle is what matters.

Based on our indicators we see a continuation of 2004. Therefore, we suggest to sell in May and go away. For the other two periods that match today's indicator level, the next three months were also down months. However, the U.S. indicator level is at a bullish level, which signifies that there will not be another flash crash. That volatility will not increase to absurd levels as in the flash crash. The market will trend down for three months starting in a week or two, with occasional pops.

What are the ways to play the U.S. stock market in the next three months?

Raise cash to at least 50%. Wait for three months and then re-deploy that cash.

Keep your current portfolio but buy protection for the next three months. This could mean buying inverse ETFs such as ProShares Short S&P 500 ETF (SH) to protect some or all of your portfolio. One may also want to short the European market since the paper above suggests that the seasonal effect is strongest in Europe. One can either short an European ETF such as iShares S&P Europe 350 (IEV) or buy an inverse ETF such as ProShares UltraShort MSCI Europe (EPV).

Long volatility by buying a call on the VIX or buying iPath S&P 500 VIX Short-Term Futures ETN (VXX). Currently the VIX is around 15, below its long-term average. However, I suggest against this since our indicators suggest the next three months will not be very volatile but more of a slow downward trend. The market could trend down with the VIX not increasing by very much or at all.

To conclude, it matters where we are in the investment cycle, and our research indicates that the next several months will be down months.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.