"Sell in May" is a simple and profitable maxim, but as the Dow Jones and S&P 500 break to new highs, many investors are asking, "Why haven't we sold off this year?"
In this article I will discuss how developments in computational linguistics and sentiment analysis can help explain why May has been such a strong month in 2013 and what to expect in the coming months. Below is a chart of the index (SPX) over the past 3.5 years with red lines indicating the start of May.
Historically, the payoff for selling in May and buying in November has been quite attractive. Analysts at Stock Trader's Almanac recently back tested the "Sell in May" investment strategy. Their results indicate that if an investor had sold the Dow Jones Industrial Average at the end of May and purchased again at the end of October, their initial investment of $100,000 in 1950 would now be worth $8,420,938 in 2013. On the other hand, investing at the beginning of May and selling at the end of October would have turned $100,000 in 1950 into $83,740 in 2013. The results do not account for dividends or transaction costs and below is the equity curve associated with this type of investment strategy.
May of 2013
Many traders and investors that sold at the end of April watched the index rise and turned into "panic buyers," stepping into the market to avoid missing a rally fueled by central bank policy.
But why has the aggregate market been buying more than selling? There are a number of reasons, but one persuading influence is the overall sentiment of news around the world that is being delivered to executives, traders, and investors. Current news media publications have less fear-sentiment than they have had in years. As we know from neuroeconomics, fear is the emotion that stirs impulsive behavior and irrational thinking when individuals are making economic decisions under uncertainty. The figure below compares price with the MarketPsych Fear Index for the S&P 500.
News aggregated from millions of news sites and analyzed for emotional content by MarketPsych clearly indicates that fear sentiment has nearly vanished from the media since 2009. Below is a chart of fear sentiment over the past year, illustrating the inverse relationship between fear sentiment and index prices.
As we approached May of 2013, fear sentiment hit record lows in the MarketPsych Fear Index for the S&P 500. This can be clearly distinguished from 2012, when there was a spike in fear sentiment in the last week of April, just before equities sold off in May.
Feelings of optimism and trust also shed light on the recent price action and are beginning to indicate that this rally is losing steam, because trust as it pertains to the S&P 500, is declining for the first time in more than seven months. See below.
In my experience, both optimism and trust can also largely influence prices. Furthermore, with fear at all-time lows, it is wise to consider the words of Warren Buffett, "Be fearful when others are greedy and greedy when others are fearful."
What This Means To Stock Holders
Equity holders are still faced with the same question, "Do I step in now or wait for another pullback?" The advice I have given to dozens of individual investors is to begin profit taking. Many that stepped into the equity markets in January have already earned a phenomenal 6 month return.
As trust sentiment is indicating, confidence in the near term is starting to weaken. Does this mean that we will not rally another 10% this summer? Not necessarily. Remember, the global economy is in uncharted territory, but we are seeing the first signs that equity markets could slip as fear sentiment and optimism begin to return to more normal levels.
One of my best suggestions is to take advantage of the power of VIX products like VXX, particularly when implied volatility levels are so low. A small amount of insurance can go a long way to avert losses and ensure there is cash in your account to buy on the next dip. A highly effective way to insure one's portfolio is to open a ratio spread on or that has enough duration that it can protect your portfolio one month at a time and in the face of a rally is not going to instantly lose all of its value.
To keep your portfolio safe, always take advantage of the data available so that you know when to get ready for a rainy day.