SERIOUS MONEY:IT IS said that bull markets climb a wall of worry. That certainly proved true during the first four months of 2011, as the world's stock market indices marched higher and delivered total returns of some 5.5 per cent in local currency in the face of a seemingly endless barrage of unfavourable shocks that included political upheaval in the Middle East and north Africa, the devastating earthquake and tsunami that struck Japan, not to mention the trauma that continues to afflict the euro zone's periphery.
The resilience has contributed to a general air of complacency among investors. They would do well to remember the old stock market maxim: “Sell in May and go away, come back on St Leger day.”
The simple trading rule posits that investors would earn better returns if they sold their stock holdings at the beginning of May and remained on the sidelines until St Leger’s day – the date of the world’s oldest classic horse race run at Doncaster on the second Saturday in September. It has been run each year since it was founded by Col Anthony St Leger in 1776.
The maxim has been part of stock market lore since at least the 1960s, though the rule has been modified in recent years and popularised as the “Halloween indicator”, whereby investors exit the stock market at the end of April as before, but remain in cash until the beginning of November.
Despite the modification, the trading strategy remains remarkably simple to execute and readers would be right to question whether the rule could truly be relied upon to produce superior risk-adjusted returns net of transaction costs and taxes in today’s competitive markets.
The first comprehensive study of the Halloween indicator was performed by Sven Bouman of Aegon and Ben Jacobsen of Erasmus University. They demonstrated in an article published in the American Economic Review in 2002 that holding cash from the beginning of May to the end of October and being fully invested in the equity market for the other six months performed better than a simple buy-and-hold strategy in 36 of the 37 stock markets examined.
Bouman and Jacobsen analysed stock market data from January 1970 through August 2008 across the various country indices and discovered that mean monthly returns were higher over the half-year period to end-April than over the other six months to end-October. Furthermore, the returns over the May-October period were often negative or less than the short-term interest rate available on cash.
The results of the study imply that the annual excess return generated by stocks relative to cash as compensation for risk has historically been earned in just six months of the year. And, since the authors also found that the standard deviation of returns was similar in both six-month periods, a simple Halloween switching-strategy can be employed by investors to reduce risk significantly and simultaneously enhance returns.
The authors demonstrated that the trading rule worked not only in developed markets such as Germany, Japan and the United States, but also emerging bourses such as Brazil, Russia and Turkey.
The effect was particularly pronounced across European markets, including Ireland, while New Zealand proved to be the only exception of the 37 markets studied.
The article traced the existence of a “Sell in May” effect in the British market as far back as 1694, while Jacobsen, alongside Cherry Zhang of Massey University, revealed in a separate but related paper published in 2010 that over the past three centuries, the strategy has worked in Britain almost 63 per cent of the time over one-year horizons, roughly 70 per cent of the time over-two year horizons, and more than 80 per cent of the time over five-year horizons.
Importantly, the same paper shows the effect had not diminished through time and that the results remained both economically and statistically significant.
Investors may well dismiss the Halloween indicator and argue they have no option but to invest in stocks given the dearth of low-risk assets offering a reasonable return in today’s ultra-accommodative monetary environment.
However, development of the optimism-cycle hypothesis by Ronald Doeswijk of Robeco Asset Management reveals the seasonal pattern in stock market returns can be exploited through a simple sector-rotation strategy.
Doeswijk’s optimism-cycle hypothesis assumes that investors “think in calendar years instead of 12-month rolling forward periods”.
He argues that investors begin to look towards a new calendar year with excessively optimistic expectations as winter approaches, and adjust their calendar-year estimates slowly through the early months of the new year as reality fails to match their high expectations. Doeswijk notes that global earnings growth revisions correspond closely to the seasonal pattern in stock prices, and posits that “cyclical stocks with their high sensitivity to the economic cycle” should benefit from the overly optimistic expectations during the winter months, while defensives should perform relatively well in the summer months given “worsening economic expectations”.
The Robeco strategist examined a “global zero-investment strategy” from 1970 through 2003 “that is long in cyclical stocks and short in defensive stocks during the winter period, and short cyclicals and long defensives during the summer”.
The results were impressive as the strategy generated an annualised simple return of 7 per cent and worked in “both up and down and low and high volatility markets”.
The old maxim “Sell in May and go away” will be dismissed by most investors, but a reduction in equity allocations combined with a switch from overpriced cyclical stocks to defensives would appear to be the order of the day.
charliefell.com
