AAII Investor Update: Stay in Stocks or Sell in May?

“Sell in May and go away” is strategy that some investors and traders are likely contemplating right now. The adage is based on the historically weaker performance of stocks during the May through October time period. Adherents shift from stocks to cash at the beginning of May and then invest back into stocks at the start of November.

Historical performance shows there are best and worst six-month periods for stocks. Jeff Hirsch at the Stock Trader’s Almanac calculates that the Dow Jones industrial average has an average return of just 0.3% during the worst six-month period (May through October) since 1950. Conversely, during the best six months (November through April), the Dow has an average gain of 7.5%. Sam Stovall at S&P Capital IQ says the S&P 500 has risen by a mere 1.2% during the average worst six-month period, while rising 6.9% during the average best six-month period. (Sam’s numbers go back to 1945.)

Certainly, last year made selling at the end of the April seem like a prudent decision. From the end of April 2011 to the end of October 2011, the Dow lost 6.7%. Using the October 4, 2011, intraday low as the endpoint, the drop worsened to 19.1%.

As we reach the end of April this year, the problems in Europe that caused last summer’s weakness (e.g., Greece’s sovereign debt) have not gone away. Plus, Spanish bond yields have recently risen, French president Nicolas Sarkozy is in a closely contested run-off, the Dutch coalition government has collapsed and Britain’s economy is contracting. In Asia, China’s economy has shown signs of slowing, and Standard & Poor’s just lowered its outlook for India. In the U.S., many politicians remain more interested in bickering and getting quoted than agreeing on long-term solutions.

Even with these legitimate concerns, things could still go right or, at least, conditions could hold up well enough to support stock prices. Europe could simply muddle along, as opposed to worsen. China’s economy may slow less than forecast. Gasoline prices in the U.S. may have peaked (fingers crossed). The U.S. economy may maintain its uncomfortably slow, but ongoing, recovery. (The Federal Reserve boosted its 2012 GDP growth projections yesterday.) Plus, low valuations could limit any downside to stocks. (The S&P 500 is trading with a forward-looking price-earnings ratio of 12.9.)

You also need to consider the downside of selling stocks. Yields on six-month Treasuries are 0.14% and Bankrate.com says money market accounts are yielding 0.46%. Your broker will charge you commissions for selling stocks, and if you sell shares in a taxable account, the IRS will bill you too. Then there is the question of when you will get back into stocks. Were you buying during last August’s or October’s lows, or were you selling? What about at the start of last November?

My cracked crystal ball cannot predict how much or how little downward volatility we will see over the next six months. Given how strong the first quarter’s rally was, a summer pause in the markets would not be surprising, but a pause is far milder than a correction. Then again, if global (or domestic) economic conditions surprise to the upside, summer flowers may not be the only thing blossoming. What I can say is that you will be taking a risk either way, but over the long term, stocks reward those who take prudent risks.

A middle-ground strategy is to see if your portfolio allocation is still close to your targets at the start of May and the end of October. If your allocations are more than five percentage points off target, rebalance. For example, if your strategy calls for a 60% allocation to stocks and stocks currently account for 66% of your portfolio, reduce your stock allocations back to 60% and shift the proceeds into the asset class that is currently underweight (e.g., bonds). This allows you take advantage of the best and worst six-month periods by selling high and buying low, while still adhering to your long-term investment plan.

More on AAII.com

• Think Twice, Even Thrice, Before Trading – Most investment newsletter advisers would have had better returns if they reduced the number of their buy and sell transactions, according to a study by Mark Hulbert.
• Best Practices for Portfolio Rebalancing – This Vanguard study explains why a 5% threshold for rebalancing is a good middle ground for realizing the risk control benefits of rebalancing and minimizing the costs of doing so.
• AAII Asset Allocation Models – Not sure how you should be allocating your portfolio? Our Asset Allocation Models can provide a guide.
• How Much Attention Do You Pay to Seasonal Factors? – Tell us on the AAII Discussion Boards.
• Don’t forget to take the Sentiment Survey.

The Week Ahead

More than 100 members of the S&P 500 will report earnings next week. Included in this group is Dow component Kraft (KFT), which will report on Thursday.

The week’s first economic report will be March personal income and spending, which will be published on Monday. Tuesday will feature the April ISM manufacturing index and March construction spending. The April ADP Employment Report and March factory orders will be published on Wednesday. Thursday will feature the April ISM non-manufacturing index and the first estimate of first-quarter productivity. April jobs data—including the change in nonfarm payrolls and the unemployment rate—will be published on Friday.

No Federal Reserve officials are scheduled to make public appearances next week.

AAII Sentiment Survey

Bullish sentiment fell to a seven-month low in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 3.5 percentage points to 27.6%. This is the lowest level of optimism recorded in the survey since September 22, 2011. This is also the fourth consecutive week that bullish sentiment has been below its historical average of 39%.

Neutral sentiment, expectations that stock prices will stay essentially flat over the next six months, was unchanged at 35.0%. This is the fourth time in five weeks that neutral sentiment has been above its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 3.6 percentage points to 37.4%. This is the third consecutive week that bearish sentiment has been above its historical average of 30%.

The difference between bullish and bearish sentiment, the bull-bear spread, worsened to -9.8 percentage points. This is the first time the spread has been negative for three consecutive weeks since October 6, 2011.

There does not seem to be one single factor that is dampening individual investor optimism. Rather, it is the combination of more volatile market conditions, concerns about the pace of economic growth, high gasoline prices, the ongoing European sovereign debt crisis and uncertainty about China’s economy that has caused more investors to be more pessimistic than optimistic about the short-term direction of stock prices.

This week's special question asked AAII members if they viewed the recent rise in Spanish bond yields as a continuance of the negative headlines out of Europe or if the higher yields have caused them to be more fearful than they were a few months ago. Approximately half of the respondents said the event has not changed their sentiment, but rather they viewed it as a continuation of the ongoing sovereign debt problems. A notable number of respondents, however, said they are more fearful than they were a few months ago.

Here is a sampling of the responses:

• “It seems to be a continuation of the negative headlines that will probably go on for years.”
• “I have never stopped being fearful about Europe.”
• “Europe will go up and down during the next two years. The European Central Bank and the IMF will keep any bad situation from spreading.”
• “Not more fearful; I just don't see any real improvement.”
• “I am more fearful because the Spanish economy is so much larger than the Greek economy. This contagion in Europe is not over yet.”

» Take the sentiment survey