Monaco & The Sell-In-May Fallacy

Sell in May, go away. That’s what they say. It has been an effective strategy in recent years, although the date you needed to come back has varied each year. In any case, over the next weeks we’ll get to understand whether this simplistic trading rule will work again this year.

Many are shouting it from the rooftops. To be sure, there are plenty of negatives to point to as triggers, and asset prices do look high, if you can interpret such information from simplistic time series charts. If May does prove to be a down month, then those currently shouting from the rooftops will transform themselves into oracles. They “knew” because it was “obvious.” But they don’t know, and it’s not obvious.

In recent years, financial markets have often been compared with casinos, and the comparison is understandable as in both places economic outcomes are dependent on the uncertain path of the future, and – dare I say it – a degree of chance. Yet, there are some important differences.

Games of chance are defined by a negative probabilistic outcome, the house always wins in the end. And each iteration of the game is fully independent of previous iterations. Thus, in Monaco in 1913, it was possible for black to come up on the roulette wheel no less than 26 times in succession. Each time it happened, players became ever more convinced that the next outcome would be red. They were wrong to believe it; the roulette wheel has no memory so each round of the game had a fully independent outcome. (This event became famously known as the Monte Carlo Fallacy.)

The sell-in-May fallacy is slightly different. Whilst the statistics surrounding this phenomenon can be argued in both directions, depending on your choice of measurement, time period and averaging, there is unarguably a degree of seasonality to markets. And the statistics of autocorrelation tell us that, unlike die, coins or roulette wheels, equities do in fact have some memory. A move up is more likely to be followed by another move up.

The seasonality of May is for higher volatility. Partly this is reflexive – volatility is caused by investors trying to avoid volatility. Other possible triggers are the shifting of the northern hemisphere from spring to summer, which changes the tempo of society at a biological level (see John Coates' research) and the payment of dividends, after which equities naturally tend to decline.

So, May does have a seasonal tendency, but it is not definitively biased towards selling. And even though stocks do have some memory, it doesn’t trump fundamentals. These should be interpreted independently each May. And here we see reason not to automatically sell this May, despite supposedly high prices.

Indexes may look high, but it is arguable that valuations do not. In the latest World Economic Outlook, the IMF notes that when compared to cost of asset replacement, equities actually look cheap. More important, the economic cycle takes longer than a year to play out, so by definition we are not repeating the same part of the cycle this year that we experienced last May.

It is true that Europe is still in recession, but this is not out of line with expectation, and should give way to improvement in the second half of the year. It is also true that US economic statistics have weakened in recent days. This too is in line with expectation. The reason the US economy is slowing is because government spending is declining. This can be read positively. Nations influence economics through fiscal spending and interest rates. When interest rates start rising, financial market volatility initially rises. Then it calms as investors recognize that rising rates are pursuant with a strengthening economy. The same should be expected of fiscal tightening. Initially it causes uncertainty, but ultimately it reflects a healthy aspect of the cycle, even when politics are difficult.

Over in the emerging world, the story is even more clouded. Those arguing that the emerging markets are a simplistic commodities-construction play have been disappointed. China is showing signs of a slowdown, yet the mood in Asia is as positive as ever, few on-the-ground believe the emerging markets story is over – local consensus is that it is evolving.

Chinese growth over the next five years will continue to drive the global economy, supporting a wide range of exporters in the West; and dovetailing with the US growth cycle. Japan has sparked expectations of increased demand too. All of this will ultimately aid Europe. The growth cycle is far from finished.

Sell in May if you will, but don’t claim it’s obvious, it isn’t, and who can say with certainty when is the right time to buy back? The prudent course is to hold quality positions, and continue buying if volatility creates an opportunity to do so.