Seasonal Softness Ahead?

Sell in May then walk away? S&P says yes, with a caveat

The S&P 500 index just eclipsed the 1,500 mark for the first time since September 11, 2000. Market sages are now talking about overtaking the S&P 500's old high of 1527 in the next two months. At this rate, the S&P 500 could be up 17% for the full year.

But in light of eroding fundamentals, many investors must be wondering if the recent market advance is sustainable. It's no wonder investors are considering the old Wall Street adage: "Sell in May then walk away."

S&P Equity Strategy believes investors would be wise to heed the advice, but in a slightly altered fashion.

There is truth in the old adage, in our opinion. Since 1945, the S&P 500 posted an average price gain of 7.1% during the November through April (N-A) period, versus a rise of only 1.6% from May through October (M-O), implying that greater profits could be made elsewhere. In addition, the performance during N-A outperformed M-O 69% of the time, as was the case in the last 12 months. We think there are several reasons for this pronounced seasonal strength and weakness.

From the perspective of seasonal sluggishness, history shows that the S&P 500 has posted its weakest three-month average performance in the third quarter, as investors may be focusing more on their tans than their portfolios. Also, analysts may be more inclined to reduce their full-year earnings estimates late in the third quarter than they would have been in the first or second, thus helping make September the worst performing month of the year.

What's more, October is historically a month in which the market establishes a bottom, so the S&P 500 enters November at a fairly low level compared with other months. This gives the N-A period the advantage of starting at a lower base.

The above-average strength in the N-A stretch may be aided by large cash infusions into the market: IRA and 401(k) contributions, as well as the investment of bonuses and tax refunds. In addition, November is also around the time of year that analysts begin looking ahead by five quarters, rather than just focusing on the final one or two.

N-A also has been fairly consistent in recording advances that have been above the long-term average. Since 1945, the S&P gained 4.5% or less (half of its long-term annual average of 9.0%) only 41% of the time - in other words, it exceeded a 4.5% advance 59% of the time. In M-O, however, the S&P gained less than 4.5% in 58% of the cases.

Since the average M-O return is little different than holding cash, why incur the transaction cost and tax consequence?

Here's one idea. Since 1990, which is as far back as we go with S&P 500 sector-level data, we find that while the cyclical sectors like financials, industrials, and materials (and consumer discretionary and information technology to a lesser extent) typically beat the market during N-A on both an average price appreciation basis and a frequency of outperformance standpoint, it was the consumer staples and health care groups - the defensive safe havens - that did the best.

Had an investor owned the S&P 500 from N-A, then rotated into the S&P 500 consumer staples or health care sectors from M-O, and then rotated back into the S&P 500 from N-A, and so on, they would have seen their annual return rise from the 9.2% recorded for the S&P 500 to 12.7% for consumer staples and 13.0% for health care. \

In 2006, while the S&P 500 rose 5.1% from M-O, the S&P consumer staples index gained 8.8% and the S&P 500 health care index increased 7.8%.

The consumer staples sector is tracked by the Select Sector SPDR-Consumer Staples exchange-traded fund (XLP), while the health care sector is tracked by Select Sector SPDR-Health care (XLV).

The old adage appears to have some merit. Whether it will work again is anyone's guess. We happen to think it will, however. In fact, S&P's Equity Strategy Group recommends overweighting the S&P 500 consumer staples, financials, and health care sectors.

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