Sell in May -- Market Timing That Works

Virtually every simple method for timing the stock market is utter hogwash. That anyone buys into such mechanical "systems" goes to show just how gullible many investors are.

But the old saw "Sell in May and go away" is a startling exception. It really has worked over the long haul in the U.S., as well as in foreign countries. So has the complementary "Halloween effect."

"Sell in May" is a simple strategy. It calls for you to sell your stocks on April 30 (okay, not quite in May) and buy them back at the end of October. That allows you to cash in on the Halloween effect, which holds that stocks deliver more treats than tricks between that ghoulish holiday and the end of April.

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Had you bought stocks last October 31, you would have done quite well. From that date through April 15, Standard & Poor's 500-stock index returned 11.2%. By contrast, during 2012's unfavorable six months, the S&P 500 returned just 2.2%.

The Halloween effect doesn't work every year. But, on average, over the past 50 years, the S&P returned 8.5% from November through April, compared with just 2.4% from April through October, according to Morningstar.

There's more: An academic study examined the Halloween effect in 108 countries over as long as 319 years — and found that it worked. Not in every country, but in the overwhelming majority of them.

The study, whose lead author is Ben Jacobsen, a finance professor at Massey University in New Zealand, found that worldwide stock markets rose an average of just 2.4% from May through October. From November through April, by contrast, stocks gained an average of 6.9%. (The study examined only price gains because dividend data often isn't available for earlier years.) You can read my October piece on the study here.

No one knows why the Halloween effect has worked — and has worked so widely and consistently. Jacobsen theorizes that it has something to do with people selling stocks to raise cash for summer vacations. That would explain why the strategy does best in Western Europe and almost as well in the U.S. Because these areas are relatively affluent, their inhabitants are more inclined to spend the most on vacations. The growing number of people taking vacations and their rising costs would also help explain why the Halloween effect has strengthened markedly in the past 50 years.

Unfortunately, the approach of May isn't the only reason to be cautious about stocks today. My main concern is the sequester — the spending cuts that Congress and the president agreed to because they couldn't cut a deal on long-term reductions in government outlays.

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Spending cuts make no sense with the economy still stuck in low gear and unemployment so high. Europe has been trying austerity during hard times, and the result has been a deepening recession.

The $85.4 billion in spending cuts this fiscal year, coupled with a two-percentage-point rise in the payroll tax, will reduce gross domestic product this year by roughly 1.5 percentage points, economists estimate. "You can't take more than 1.5 points of GDP out of the economy more or less overnight and expect nothing bad to happen," Ian Shepherdson, chief economist at Pantheon Macroeconomic Advisors, said in a note to clients. "In the labor market, at least, we see a real risk of even worse news down the line."

Even more troubling, roughly $90 billion in fresh cuts will kick in next October unless Congress and the White House can agree on a saner approach.

Corporate earnings are another reason to worry about your stock investments. Corporate earnings in the first quarter are likely to rise by a meager 0.5% from the same period in 2012, says Sam Stovall, chief equity strategist at S&P Capital IQ.

With the labor market moribund, robust corporate earnings coupled with the Federal Reserve's loose-money policies are the main reasons stocks have performed so well over the past four years. Now the earnings side of the equation could be in jeopardy.

Meanwhile, the mess in Europe keeps worsening. The euro zone has been remarkably lame in trying to remedy its ailments. Mainly, it suffers from the same kind of political gridlock the U.S. does — with southern European countries arguing for more spending and those in the north, which would foot the bill, favoring austerity. Consequently, almost the whole continent is in a deepening recession. That can't be good for the U.S.

What's an investor to do? In spite of the relatively poor results historically in the April-through-October period, the market still usually goes up. And no method is foolproof.

Besides, some market indicators are flashing green. Stocks are still reasonably valued. And the market remains technically strong by most measures (for example, many more stocks have been rising than sinking during the rally). It's rare for bear markets to begin until a market advance is led by relatively few stocks.

So I'm certainly not recommending that you dump all your stocks now. What I think does make sense is to cut back by five to ten percentage points — and plan to buy back on Halloween.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.