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World stock markets enjoyed an almost 25 per cent gain from the cyclical low registered last October through mid-March, as the myriad of concerns weighing on investor sentiment slipped into the background.  Investor enthusiasm for risk assets returned, as the previously growing concern that the global economic expansion was set to falter all but vanished, as a steady stream of data surpassed market expectations.

The resilience has contributed to a general air of complacency amongst investors, who 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 that is run at Doncaster on the second Saturday in September and has been run each year since it was founded by Colonel 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 who 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 all of 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 significantly reduce risk and simultaneously enhance returns.

The authors demonstrated that the trading rule worked not only in developed markets such as Germany, Japan and the U.S., 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.

Furthermore, the article traced the existence of a ‘Sell in May’ effect in the U.K. 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 the U.K. 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 that the effect has not diminished through time and that the results remain both economically and statistically significant.

Investors may well dismiss the ‘Halloween’ indicator and argue that 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 that 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 twelve-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 strategist at Robeco 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 seven per cent and worked in “both up and down and low and high volatility markets.”

The cyclical bull market in stocks appears to have struck a speed-bump, as the ‘stop/go’ nature of US recovery, a resumption of euro-zone crisis, and continued softness in Chinese economic data, tests investors’ nerve.  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.

Previously posted on www.charliefell.com

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