One of the biggest investment clichs, "sell in May and go away don't come back until St Leger Day", always does the rounds at this time of year. The theory is that you dump stocks just before big institutional investors take profits and sell up ahead of their summer break. You get back in just before the St Leger horserace in September, when prices rise as the big players return to invest. Sounds like an easy route to riches. But can investing be all that simple?
Trends shouldn't exist
The "sell in May" proverb is basically about trend-following. Trends are a product of crowd behaviour, or 'momentum'. Believers in efficient markets theory say there is no such thing. Investors are rational and level-headed, coolly analysing all information known about a firm before buying or selling with one aim: to make the biggest possible profit.
That's the basis for the "efficient market hypothesis" (EMH), which implies there are only two ways of making money. One is pure luck. Or there's cheating. But "insider dealing" (trading on price-sensitive information) is illegal. So no investor (or fund manager) can consistently beat the market without being either phenomenally lucky or risking prison. Hence, EMH says, your best bet is to find the cheapest way to track the market using, say, cheap exchange traded funds.
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Just how rational is Mr Market?
The trouble with EMH is it ignores the fact that two emotions, fear and greed, dominate investing as much as rational analysis. We're all prone to what Charles Mackay in 1841 labelled "the madness of crowds", otherwise you'd never see anything as irrational as the technology bubble of the late 1990s, or our more recent credit and property bubbles. EMH also underestimates the power of the market's "greater fools". Lacking the same information or wit as others, they buy for far longer and at far higher prices than any rational investor. And keep trends going in the process.
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Besides, what is rational for one of EMH's "profit maximisers" may not make sense for the market as a whole. US ecologist Garrett Hardin called this the "Tragedy of the Commons". Take herders grazing cattle on a common pasture. One decides he can maximise his own wealth by sneaking in an extra cow. It works until other herders notice and copy him. Eventually, overgrazing will deprive all the herders of a living.
But exploiting a trend isn't easy
Perhaps the final nail in the coffin of pure EMH is the existence of arbitrageurs. These professional traders take big risks to make money by exploiting the many share pricing oddities that EMH says can't occur. But copying them isn't easy. Take a recent Goldman Sachs study, quoted on Reuters. It shows that since the start of 2008 the cumulative gain from holding the S&P 500 from 2pm to 4pm each day has been 35%. The cumulative loss from holding the S&P between 9.30am and 2pm is 54%. The strategy is clear. Buy S&P stocks at 2pm and sell at 4pm. Then get up and short sell the S&P at 9.30am before buying at 2pm. Seems simple enough, but there's a big catch.
No free lunch
"If the trend was really as strong as Goldman Sachs says it is, I don't understand why they told anybody," says stockmarket historian David Schwartz in the FT. If everyone spots the same chance, "first mover advantage" disappears. But even if the S&P trend isn't widely known, taking advantage can be tough. You'd have to place the four Goldman trades every day, incurring four sets of dealing costs. You may need to pay for stop losses, to limit the damage from shorting the S&P at 9.30am should it rise sharply. Every time you make a gain on, say, the 2pm to 4pm leg, there is a potential capital gains tax liability. Plus the whole thing's quite a daily chore. So how about trying the simpler "sell in May" strategy?
Sadly, it seems it's not worth the bother either. As John Mauldin of Millennium Wave Securities points out, a study of the MSCI World Index since 1969 suggests that across 18 markets the best period to be out of stocks is in fact from May to the end of October. But to get the best gain, you have to get the timing spot on, and then there's tax and dealing costs to consider. In all, says Mauldin, after you take account of that, an investor who just invested in and held, say, the S&P 500 over the same period would have made an annual return of 11.9%. This is 0.7% a year higher than someone trying to time each "good" and "bad" half-year period.
However, just because you shouldn't follow the advice of the proverb in a knee-jerk manner, doesn't mean you should just be sitting cheerfully on your portfolio. Now could be the ideal time to take advantage of the recent rally to get rid of any consumer-facing stocks or banks you are still holding on to. As Thomas Becket of PSigma Investment Management warned at our roundtable last week, the earnings season is looming "like a Horseman of the Apocalypse". That's a better reason to approach May cautiously than following a tired old shares adage.
