A Smarter Seasonal Stock Strategy

"Sell in May and then walk away"? Not so fast. Here's a better way to play the market's tendency to underperform in the summer and fall

The Dow Jones industrial average just eclipsed the 13,000 mark. Investment sages are now talking about the next market milestone: the possibility that the S&P 500 could top its old high of 1527 in the next two months. At this rate, the S&P 500 could be up 17% for the full year. What with the market up more than 13% in 2006, it's no wonder investors are now considering the old Wall Street saw "Sell in May and then walk away," particularly in light of eroding fundamentals. Maybe investors would be wise to heed the advice, but in a slightly altered fashion.

There's something to the old truism, in our opinion. Since 1945, the S&P 500 posted an average price gain of 7.1% during the November-through-April period, vs. a rise of only 1.6% from May through October, implying that greater profits could be made elsewhere. What's more, the performance during November-April outperformed May-October 69% of the time, as was the case in the last 12 months.

Reasons for this pronounced seasonal strength and weakness may be several, in our view. 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.

Cash Flow

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 to other months. This gives the November-April period the advantage of starting at a lower base.

The above-average strength in the November-April 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.

November-April 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 May-October, however, the S&P gained less than 4.5% in 58% of the cases.

The Cost of Selling

Take a look at the first of the accompanying charts (right). Splitting this analysis into the four-year Presidential cycle, it appears that the "Sell in May" adage works very well during pre-election years (such as 2007), as the S&P gained less than 4.5% only 13% of the time in the November-April period, while the market gained less than 4.5% in 60% of the cases in the May-October months. This year, from October 31, 2006, through April 27, 2007, the S&P 500 advanced 8.4%.

Finally, in pre-election years we also find that the November-April performance beat the May-October results 80% of the time, meaning that should history repeat itself (and there's no guarantee it will) there's a good chance the market may rise less than 4.5% in the coming May-October period, and there's a high probability that the "500" will post a return in the next six months that's below the return of the past half-year.

Either way, investors may not want to really "Sell in May." Since the average May-October return is little different than holding cash, why incur the transaction cost and tax consequence by selling?

Safe Sectors

If you're like me—meaning you don't like playing the market-timing game and would rather stay invested at all times—wouldn't it be better to find a way to be long the S&P 500 from November-April and then rotate into some other area that has typically delivered market-beating performances from May-October?

Well, I may have a solution. Take a look at the second chart on the right. 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 November-April on both an average price appreciation basis and a frequency of out-performance standpoint, it was the Consumer Staples and Health Care groups—the defensive safe havens—that did the best during those periods of seasonal sluggishness (May-October).

Check out the third and final chart. Had an investor owned the S&P 500 from November through April, then rotated into the S&P 500 Consumer Staples or Health Care sectors from May through October, and then rotated back into the S&P 500 from November-April, and so on, they would have seen their annual return rise from the 9.3% recorded for the S&P 500 to 12.7% for Consumer Staples and 13.1% for Health Care. And remember, the Staples and Health-Care Indexes beat the S&P 500 during May-October about two out of every three years. In 2006, while the S&P 500 rose 5.1% from May-October, the S&P Consumer Staples Index gained 8.8% and the S&P 500 Health-Care Index increased 7.8%.

Contrarian Call

So there you have it. 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. We advise overweighting the S&P 500 Consumer Staples sector, due to the counter-cyclical nature of demand for many of the sector's products, coupled with increasing international sales exposure, which we believe will likely cushion vulnerability to slowing U.S. economic growth.

We advise overweighting the Financials sector in a contrarian call that reflects an improving technical outlook and our view that negative subprime-driven news flow is now fully discounted in valuations as evidenced by the group's weak near-term relative strength and high short sale levels.

And finally, we recommend overweighting the Health-Care sector. In an environment of slowing earnings-per-share (EPS) gains for the overall market stemming from an aging economic expansion, we believe investors will gravitate toward sectors with high EPS growth visibility and historically defensive characteristics.

Industry Momentum List Update

Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Subindustry Company S&P STARS Rank Price (4/27/07)
Apparel, Accessories Quiksilver (ZQK) 5 $14
Consumer Electronics Harman Intl. (HAR) 3 $123
Diversified Metals & Mining Freeport-McMoRan Copper & Gold (FCX) 3 $68
Electric Utilities Exelon (EXC) 4 $76
Fertilizers & Agr. Chem. Monsanto (MON) 3 $60
Food Retail Kroger (KR) 4 $30
Independent Power Producers AES (AES) 4 $23
Integrated Telecom. Svcs. Citizens Communications (CZN) 5 $16
Internet Retail Amazon.com (AMZN) 3 $63
Metal & Glass Containers Ball Corp. (BLL) 4 $51
Office REITs Boston Properties (BXP) 3 $119
Retail REITs Simon Property (SPG) 5 $117
Steel U.S. Steel (X) 4 $103
Tires & Rubber Goodyear Tire & Rubber (GT) 3 $34
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