Investor's Business Daily recently interviewed three investment strategists to offer advice in responding to the S&P 500's (SPY) 10% rally so far this year and 23% rise since the relative low of June 2012. One of the interviewees, Simon Maierhofer (the founder of iSpyETF), offered this advice that is representative of the "Sell in May and Go Away" sentiment:
"Based on the market's recent modus operandi, the second quarter of 2013 will be a tale of two markets. The first part of the quarter should see rising equity prices, the second part should see falling prices. If you print out a five-year chart of the S&P 500 and draw a vertical line on every May 1, you'll see the following pattern every single year since 2008: the S&p 500 sprints into a May high and takes a breather or collapses thereafter. The exact date of the correction varies, but the S&P 500 declined at least 10% from its May 1st level in 2008, 2010, 2011, and 2012."
Mr. Maierhofer's prediction may prove to be right. I have no idea what the price of stocks will do over the coming months, and Maierhofer seems to believe that the past patterns are likely to repeat themselves this year. That is a reasonable position. One thing I'd like to point out though is this: when you look at what some of the value investing legends such as Charlie Munger, John Templeton, Bill Ruane, and Seth Klarman have said and done, they have almost never made future predictions about stock prices.
Rather, they always speak on a specific company-by-company basis and craft a strategy that relies on reacting to stock price changes rather than trying to predict them. I will give an example to illustrate the point. Right now, BP (BP) trades at $42 per share. The analyst consensus is that the company will earn $7.50 per share in 2016. Historically, the company traded at 10-12x earnings. If the analyst estimates prove correct, and if BP trades in line with historical P/E metrics in 2016, the stock will be trading between $75 and $90. A value investor will not spend his time wondering whether the price of BP will go up 20% or fall 20% in the next couple months, but rather, will spend his time evaluating whether or not the earnings estimates are realistic, whether BP will trade in line with historical valuations three years from now, and then determine whether the risk is worth it in relation to those prices.
Once a value investor makes that determination (either in the affirmative or the negative), then he can use changes in stock prices to react intelligently (rather than worry about predicting them). If the value investor believes the earnings estimates and valuation projections are accurate (and therefore decides to invest), then he can load up on more shares of stock if BP falls to $30 this summer. And if the market gets irrational and the price of BP rises to $65 this summer, then the value investor may decide to take advantage of Mr. Market's exuberance and take the quick gain that the market offered.
The point is that if you focus on buying specific companies at a discount, you can truly follow Benjamin Graham's advice that the market exists to serve you and not instruct you. If you buy an asset at an attractive price, you can buy more if the price goes down, and perhaps sell out if you experience a quick spike. Seth Klarman, the author of "Margin of Safety", had some harsh words for those who try to anticipate the coming changes in stock prices:
"Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others. They regard securities as pieces of paper to be swapped back and forth and are generally ignorant of or indifferent to investment fundamentals. They buy securities because they "act" well and sell when they don't. Indeed, even if it were certain that the world would end tomorrow, it is likely that some speculators would continue to trade securities based on what they thought the market would do today.
Speculators are obsessed with predicting-guessing-the direction of stock prices. Every morning on cable television, every afternoon on the stock market report, every weekend in Barron's, every week in dozens of market newsletters, and whenever businesspeople get together, there is rampant conjecture on where the market is heading. Many speculators attempt to predict the market direction by using technical analysis- past stock price fluctuations-as a guide. Technical analysis is based on the presumption that past share price meanderings, rather than underlying business value, hold the key to future stock prices. In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking."
Royal Dutch Shell (RDS.B) trades at 7x earnings and offers investors a starting dividend yield of 5%. The company traditionally trades at 9-11x earnings. A value investor will spend his time thinking about what those earnings will be as well as the likelihood that Shell's valuation will return to those historical levels. If he answers in the affirmative, he'll buy. If he answers in the negative, he won't buy. It does not have to be more complicated than that. When you focus on the specifics of a company and estimates of fair valuation (that hopefully come with a margin of safety), then you can avoid all the nonsense of wondering what stock prices will do this summer. If you bought assets at attractive prices relative to true worth, then you can react intelligently to anything the market does this summer.
Klarman makes a fantastic point of why the "Sell in May and Go Away" piece of wisdom does not apply to value investors. The entire premise of that strategy is based on a prediction of the behavior of others. You are just guessing what other investors are going to do, as opposed to finding discrepancies between what a business is worth and what it is currently selling for. Klarman calls market predictions a waste of time because no one knows what the market will do. For value investors, the approach to the summer ought to be this: figure out what each stock you own is worth, and then figure out what you will do if the company gets markedly cheaper than that or markedly more expensive than that. If you can maintain that kind of clarity in your approach to stock selection, you can tune out all the noise that will surely come from the talking heads in the coming months while sticking to the general framework that has guided the successful investment decisions of men like Seth Klarman.