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This has to be one of the strangest years for the stock market that I can recall. The market is up - way up, but it feels like we are in a bear market despite the fact that we sit just 1.4% below the highest print since June 2008. The S&P 500 closed near 1402 and is up 13.3% so far in 2012, including dividends, or 11.8% without.

One of the most repeated refrains when it comes to investment platitudes is the notion to "Sell in May and go away". If only there was a simple rule like this that could deliver even most of the time. This is one of those rules that people take for granted, but it's difficult to not only find if it generally works but also to pin down the exact rule:

  • When do you sell - May 1, May 31 or the very best level?
  • When do you buy?

Rather than debate the logic, which I believe is incorrect (the idea that there is a seasonal trade in equities that can produce anything more than random results), let's just say that 2012 was a failure for this rule. Then again, unless you waited until late May, it hasn't exactly been such a terrible move to reduce risk by selling stocks. In fact, as you can see on the chart below, if you sold smaller stocks, you likely haven't suffered at all:

(click to enlarge)

The S&P 500 (NYSEARCA:SPY) is up 1% (before dividends) since 4/30, while the Russell 2000 (NYSEARCA:IWM) is down 2%. Maybe you are one of the lucky ones (or smart ones) who sold and was able to cover at a 5-10% gain if your timing was excellent, but what should investors do if they are still in this trade?

If you reduced your exposure solely because you were trying to play the alleged seasonal, you need to rethink your position, as you are running out of time and the market is looking like a coiled spring. While the S&P 500 is up over 11% in 2012, it's up less than 3% since the 2011 highs. So far, minimal damage from selling in May, but it would be silly to let a marginally bad trade turn into an investment disaster.

What if, though, you went into the trade because you were and remain convinced that the market is not a good deal? In that case, good luck. I expect that the market will keep climbing a wall of worry, as the world is full of challenges, but stocks remain one of the best deals around. The well-known risks seem to be priced in and may not play out as badly as many have feared.

So, are you supposed to listen to what seems like every pundit being interviewed on CNBC and "buy high-quality large-cap dividend-paying stocks"? To me, that trade looks played out, with stampedes into companies like ATT (NYSE:T), Home Depot (NYSE:HD) and Wal-Mart (NYSE:WMT), all of which are up at least 20%. No, I think that this is a good time to buy smaller stocks and to focus on growth.

Over the past year, while the S&P 500 has rallied 25% from what proved to be close to the depth of last year's correction, R2000 is up 21%. Typically, smaller stocks exhibit more volatility as a sector. The "beta" for the R2000 is about 1.2, which suggests the smaller stocks should have increased by about 30%.

Why the lag? I think that the primary issues have been a preference for liquidity, a focus on dividends and the exodus of the small investor. Recent data from Investment Company Institute describes the continued massive outflows from domestic equity into bonds. Mutual fund outflows hurt smaller stocks, and this is being compounded by hedge funds taking lower net positions (based on my anecdotal observations). Arguing in favor of Small-Cap strength is the strength of the dollar.

I expect that 2012 will end up looking somewhat like 2010, when the market set its low before the end of the summer and took off. Recall that the Flash Crash in May 2010 put a real damper on things, with the market printing its ultimate low in July at 1011 but closing up sharply that month. Kind of like June 2012, when we posted the correction low. At the very worst in 2010, the market was down about 10%. In 2012, we didn't even go negative.

As is typical, the hedge funds, who tend to be the marginal buyers and sellers of stocks, are going to game the finish in order to get paid. We aren't up enough for them to sell into rallies, as most hedge funds are lagging the market. According to Barron's (citing eVestment/HFN), hedge funds were up on average just 3% through July. I expect hedge funds to be buyers, and they tend to invest in smaller stocks.

I had thought it might wait until after Labor Day, but it looks to be happening a bit earlier, as last week saw a lot of action in the "tail" despite rather limited movement in the overall market. What do I mean by this? While IWM gained a bit more than SPY last week (1.7% vs. 1.1%), an astounding number of stocks in the R2000 rose quite sharply. 385 (over 19%) gained in excess of 5%, or 3X the R2000, with 32 rising more than 20%. Not bad for a quiet week! One of the big winners was Broadsoft (NASDAQ:BSFT), which I included in my article last week describing stocks that had been hammered but were still in bullish longer-term trends.

Earnings season is over, and the hedge funds need to generate performance. The "sell in May and go away" trade has failed, though "buy in June and get rich soon" (my new rule that I am backtesting) worked. I have been wrong about mutual fund flows, but God help the bears if that spigot (out of stocks and into bonds) shuts off or even reverses.

I have been using the past few months of consolidation to significantly change my Top 20 Model Portfolio. I have generally been moving into smaller companies and trying to add growth. Middleby (NASDAQ:MIDD) is a great example - the stock finally paid off after a decent report last week. We added that one at the end of June. Last week, we bought a stock ($575mm market cap) with a PE less than 10 that has grown earnings 84% over the past year and is projected to grow 25% over the next year. The reason I have been moving in this direction is that smaller stocks have lagged and PE multiples are generally low. I expect that this rally, which has been driven not by improving fundamentals but rather PE expansion, could continue to reward investors willing to take the liquidity risk of smaller stocks, especially as we get into easier year-over-year comparisons in earnings.

Source: You 'Sold In May': Now What?

Additional disclosure: MIDD is held in one or more model portfolios managed by the author at InvestByModel.com