Sell In May And Go Away; Profit Anyway

Includes: SDS, SPXS, SPY, TZA, VXX
by: Christopher F. Davis

For many of you who have been in the markets for a few years, you have undoubtedly heard of the notorious sell in May and go away adage. And why not? The markets have been on a tear in 2013. The SPDR S&P 500 ETF (NYSEARCA:SPY) is up 11% in 2013 trading at $159.68, while the Dow Jones Industrial Average ETF (NYSEARCA:DIA) is up 13.4%, trading at $148.09. This action continues the positive run that began in November after a brief 5% correction. So why do we say sell in May and go away? Generally speaking, the markets do poorly in the summer months and well in the winter months. Over the last 60 years, we have seen an average gain of less than half a percentage point from May through October, while in the winter months we have had an average gain of 7%. It seems like a reasonable time to take some profits given historical performance.

Before delving into the ways you can profit if and when the selling begins, there are fundamental triggers that could cause selling, despite the sell in May and go away fears that may cause some to sell anyway. How about earnings? A multitude of disappointing earnings reports could start a sell-off in the market. In fact, disappointing earnings from Pfizer (NYSE:PFE) today weighed on markets early in the action before they bounced back to close in positive territory. Continued reports of top line revenue and bottom line earnings that miss estimates could give more credence to the belief that an economic slowdown is on the horizon.

There is some evidence that markets are slowing (see the Chicago PMI report today) or continued weak job numbers. Housing has been a bright spot, though there is chatter of a bubble now. Although GDP grew 2.5% in Q1, it was still less than expected. More lackluster economic reports could signal that it is time for a correction in the markets. The next jobs number to watch will be reported at the end of the week. If it comes in much lower than expected, be prepared for a selloff. And we cannot forget what is happening overseas. Japan tries spending its way into economic growth, leading to deflation there, while the European debt crisis has not gone away. When it returns to the spotlight, it could be the excuse folks need to knock the financial markets down 8-10%.

So how can we prepare? When the correction starts, it could happen over the course of a few weeks. Thus, traders may want to put on some bearish positions to protect or even continue to grow capital. Those who are bearish could consider selling stock, selling covered calls on their positions, shorting stocks, buying puts or investing in a volatility or bear fund. While each of these approaches has its respective benefits and risks, in this article, I want to highlight four quick-pick ETF funds, three of which are leveraged to the downside, and one play on volatility, that could provide great short-term returns in the event of a sell in May and go away market sell-off.

ProShares UltraShort S&P 500 (SDS): For those with a risk appetite seeking to make a leveraged bet to the downside, consider a potentially profitable position in SDS. This leveraged fund seeks daily investment results that correspond to twice the inverse of the daily performance of the S&P 500. The management team of the SDS invests in common stock issued by public companies. The management team of SDS also invests in certain 'derivatives', which are financial instruments whose value is derived from the value of an underlying asset, interest rate or index.

SDS recently underwent a one-for-four reverse split to bolster the share price, as the nearly four-year bull market took its toll on this fund's value. The value of shares not only depreciated from being sold down with other bearish plays during the bull market, but was also hurt by its expense ratio (0.89%) and the fact that it is adjusted daily. Funds that seek daily performance never track the long-term performance of an underlying index due to a concept known as "slippage." More on that can be found here.

Despite this fact, daily leveraged funds such as the SDS, in periods of panic and bearishness, perform exceptionally well. Thus, a well-timed position can be very profitable. SDS currently trades at $42.12 a share. SDS has average daily volume of 10.7 million shares exchanging hands. SDS has a 52-week range of $42.06-$73.04.

Direxion Daily S&P 500 Bear 3x ETF (SPXS): For those with the highest appetite for risk, besides investors who are willing to short stocks, the SPXS can be considered for heavily leveraged bearish exposure among large cap stocks. SPXS, formerly the Direxion Daily Large Cap Bear 3X fund, seeks daily investment results before fees and expenses of 300% of the inverse of the price performance of the S&P 500 Index. As with other funds, there is no guarantee the fund will meet its stated investment objective and is subject to slippage as described above. The fund also has a higher 1.14% annual expense ratio.

The SPXS management team likes to create short positions by investing at least 80% of its net assets in: futures contracts; options on securities, indices and futures contracts; equity caps, collars and floors; swap agreements; forward contracts; short positions; reverse repurchase agreements; ETFs; and other financial instruments that, in combination, provide leveraged and unleveraged exposure to the S&P 500. Given this approach, in times of market sell-offs, the SPXS will deliver outsized returns. Thus, this fund should be considered by those who seek to profit from panic that could result from a fast sell-off that jolts the market.

SPXS currently trades at $11.48 a share. SPXS has average daily volume of 3.1 million shares exchanging hands. SPXS has a 52-week trading range of $11.45-$26.83.

Direxion Daily Small Cap Bear 3X Shares (TZA): This is my favorite way to invest in a bear market short term. It is also of the highest risk category give its leveraged nature. TZA management seeks daily investment results of 300% of the inverse of the price performance of the Russell 2000 Index (also known as the small cap index). The Russell 2000 (NYSEARCA:IWM) measures the performance of the small-cap segment of the United States equity universe and consists of the smallest 2,000 companies in the Russell 3000 Index, representing approximately 10% of the total market capitalization of the Russell 3000 Index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.

TZA actually does not invest in equity securities or stocks. What TZA does is creates short positions by investing at least 80% of its net assets in financial instruments to provide leveraged and unleveraged exposure to the small cap index and the remainder in money market instruments. TZA recently underwent a reverse split, thus it seems to be trading higher than in the past. It now currently trades at $36.35 a share on average daily volume of 6.5 million shares. TZA has a 52-week range of $36.31-$98.64.

iPath S&P 500 Short-Term VIX futures ETN (VXX): The Chicago Board Options Exchange Market Volatility Index or the VIX, is a popular measure of the implied volatility of S&P 500 market index. You may hear it often referred to as the fear gauge or the fear index. The VIX is a measure that is supposed to represent the market's expectation of stock market volatility over the next 30-day period. The VXX is a fund that is one of the better ways to track the VIX (which is not directly available to invest in), in my opinion. This investment seeks to replicate, net of expenses, the S&P 500 VIX Short-Term Futures Total Return Index. The index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500 index at various points along the volatility forward curve. The index futures roll continuously throughout each month, from the first month VIX futures contract into the second month VIX futures contract. VXX recently underwent a major one-for-four reverse split to increase share value. The fund has an annual expense ratio of 0.89%, is currently trading at $18.97, and has a 52-week trading range of $18.26-$91.52 (please note this range does not account for shares reverse splitting).

Conclusion: Many approaches exist to position accordingly for market panic. While we have had a great bull run in the last few months and the last few years as a whole, macro news such as turmoil on Europe, bad economic reports such as weak jobs numbers and poor earnings could be what finally triggers the next selloff. I suspect markets indeed drop from a sell in May and go away perspective that is grounded on such fundamental news. For those who are brave, shorting the SPY or DIA is an option. Buying put options or selling calls on the SPY and DIA is another option for those believing the selloff is coming. Finally, allocating some funds to the aforementioned bearish funds is an option, as they will perform very well and yield short-term gains in response to the market panic that will ensue if sell in May and go away becomes reality.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TZA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.