Monday, May 5, 2014

An Update on May to October Seasonality

In a sign of how short investors' memories are, one of the newest memes is that equities are unlikely to be weak this summer because they already corrected during the first four months of the year.

Anyone remember 2010 or 2011? Both started weak and got weaker in the middle of the year.

How about 2000, 2001, 2002, 2004, 2005, 2007 or 2008? Weakness early in each of these years did not preclude a second period of weakness in summer.

Stock Traders Almanac looked further back to the 1930s. In the 12 prior times that January was weak and the market then bounced back in February (like it did this year), SPX has typically suffered a second, deeper round of weakness in the summer.

None of this is to say, however, that investors should sell on May 1 and not invest again until October 31. A post we wrote a year ago stated that SPX has had a positive median return during this period of +4% since 1970. You might sell in May and buy back higher in November (post).

The point, instead, is to recognize that gains tend to be smaller and drawdowns larger during the summer than in the winter.

BAML further quantified this tendency: smaller gains (left column) versus larger drawdowns (right column) in summer than winter.

Quantifiable Edges looked specifically at those times when SPX had already fallen 5% prior to the end of April (like this year) relative to those years where it did not (like 2013). Their findings: prior weakness in the year led to greater weakness in the summer. 40% of the years that started weak had a drawdown of more than 10% during the summer. The risk/reward under this set up was negative.

So, the meme about equities likely being stronger this summer because they already corrected earlier this year is not only wrong, its backwards: weaker starts to the year have much weaker summers.

Adding to that this year is the mid-term election cycle. Again, using the data from BAML, mid-term summers have a weaker gain (left column) and an even greater likelihood of a large drawdown than other years (right two columns; compare to the prior table above). 

One more study also points to weakness ahead. Stock Almanac looked at periods where January traded below the low in December (again, early weakness in the year). Of these 21 occurrences prior to 2014, the smallest further drawdown was 3.6% (the average was 14%). For DJIA, that implies a minimum target of 15,172, 8% below today's close. 

Could 2014 skate through the next 6 months without a large drawdown? The answer is yes.  But your average risk/reward is negative for this period and the odds of a very bad period this summer are significantly higher than normal. 

Don't go away this summer. This is the year to be nimble and alert: a large drawdown would be an opportunity for significantly improved returns in the months ahead.