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Rotate in May, go away

Created:

21 April 2009

Written by:

John Hughman

They say time flies when you're having fun. But even though 2009 has so far been one of the gloomiest years in financial history and not much fun at all, the first four months of the year have passed in what seems like the blink of an eye.

That means it's time to examine another well-trodden cliché, the most famous stock market adage of all – sell in May and go away, and, if you're a stickler for detail, don't come back until St Leger's day. That's 12th September this year.

The trend is your friend

There's plenty of statistical evidence to suggest that this isn't just a lazy cliché and really does work, not least from the extensive research of two Investors Chronicle columnists, Chris Dillow and Simon Thompson. Both agree that the markets usually weaken after the end of April, although suggest that it isn't St Leger's day when investors should pile back into the equity markets, but the end of October – the so called 'Halloween effect.' That works out to a neat six months split – to steal a sporting cliché, an investment game of two halves.

Chris's analysis of monthly stock market returns since 1965 shows that returns in May to October are less than 0.3 per cent on average, compared to an average return in the remaining 6 months of 2.25 per cent. He suggests switching shares into cash over the summer/autumn months, and overcoming psychological hurdles to re-enter the equity market in autumn/winter.

Meanwhile, in his book 'Trading Secrets', Simon calculates that the six month period from the start of May to the end of October has returned just 0.25 per cent on average since 1990, against a 7.1 per cent average return from November to April. And, as he points out, the stronger the performance in April, the higher the chance of a weaker May, especially true if January's market performance was weak.

This time it's different

That sets the scene for a near perfect re-run of this simple stock market mechanism this year. The FTSE All share has risen by 5.7 per cent so far this April, after falling by 5.9 per cent in January. That repeats the pattern of 2008 – an 8.7 per cent January fall was followed by a 9.8 April rise, and then an almighty 30.8 per cent fall over the next six months.

But the trouble with clichés is that while they may be underpinned by a grain or two of historical truth – and in this case a bushel or two - they don't always hold true. Simon's analysis shows there's a one in 15 chance that this will be the year that a strong April won't be followed by a weak May. The chances of that are increased if we are in fact back at the start of a bull year market – the last time the relationship broke down was in 2003, as we entered a four-year upswing.

But those odds are still attractive, especially if, like many of us at the Investors Chronicle, you don't believe that we've reached market lows just yet – despite bullish comments from several world leaders and business bodies, there's still too much economic uncertainty out there to confidently assert that we are nearer the end of the recession than the beginning. Talk of green shoots when the seeds of fiscal stimulus are still being sown seems premature.

Rotation, rotation, rotation

Yet, many people remain reluctant to play this trend, and Chris Dillow suggests a number of reasons why investors don't make this profitable switch; he sees risk aversion, dealing costs, or pure obstinacy as the primary culprits. Dumping an entire equity portfolio based on what many see as a hackneyed investment cliché may be too bold a tactic for some.

But there are still ways to play this statistically backed investment strategy for those that want to retain equity exposure. As we know, not all sectors move in the same direction at the same time, so, just as sector rotation is commonly used to minimise downside in longer economic cycles, it can be equally applied to seasonal investing.

Historically, cyclical sectors have outperformed the market in April, while defensive sectors underperform. That chimes with what we've seen so far this year. Economically sensitive sectors including industrial engineering, real estate, financials, and electronic equipment have all risen by more than 20 per cent so far this month – general retail hasn't risen quite so much, but has gained 36.5 per cent so far this year. Meanwhile, non-cyclicals like oil & gas, pharmaceutical and tobacco have fallen, while beverages and utilties have underperformed. So, given that the recent market surge looks like a bear market rally and not a recovery, now could be a good time to switch back into defensives.

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