Get Ready for Another 'Sell in May and Go Away' Year

by: EconMatters

This is an old Wall Street adage, and if you followed this advice last year you saved your portfolio from all the carnage that took place last year around this time. The similarities between 2010 and 2011 are very apparent for the following:

  1. QE1 & QE2 inflated asset prices = long run-up with no significant pullbacks
  2. European debt & usterity issues
  3. Ending of government stimulus programs = deflates asset prices
  4. Bernanke put in markets = no sustained short presence
  5. Weak dollar = risk trade on in full force
  6. Summer doldrums = historically weaker investment months

Bad News is Bad News If Buyers Turn Sellers

If we look back at last year for guidance, we remember that the Greek and European crisis was known for months, and the selloff only occurred when conditions were optimal. As in: the Fed removing stimulus from asset prices, which led to limited upside gains versus substantial downside correction losses. Then, all of the sudden, we had a crisis on our hands, only differentiated by the fact that sellers stepped into the market, and all the sudden, bad news was everywhere.

It is only bad news in market terms if buyers decide to sell, and just like in 2010, the above reasons serve as likely catalysts for similar selling this year around this time. Think along the lines of a 20-25% correction in most asset classes over the next 4 to 5 months.

2010 Redux Strategy

Just think how much better your portfolio would look if you locked in your profits last April, parked your money in a money market fund, waited for the summer selloff, and then got back in the market during the historically stronger investment months for the last quarter of the year (October-December) when money managers push up asset prices into the year end to make their numbers.

We really have one trade right now, whether we are talking about silver, crude oil, gold, or equities, and that is the Risk-On trade. So here is what aggressive and experienced investors should do when it becomes the Risk-Off trade during the 20% correction:

  1. Go long the U.S. dollar index (DXY)
  2. Short the carry trade currency pairs: EUR/U.S.D, U.S.D/JPY
  3. Short the risk on commodity currencies: Canadian dollar, Australian dollar
  4. Long only investors: go to cash in the form of a money market fund
  5. Short equity indexes and ETFs: SPY, DIA, IWM, QQQ, XLF
  6. Short risk on commodity futures: OIL - CL, Silver - SI, Gold - GC
  7. Short Commodity ETFs: GLD, SLV, [[U.S.O]], GDX, SIL, DBA, MOO, DBC, XLE
  8. Go long bonds during the big down days via ETF exposure: TLT, TBT, TBF, TMV
  9. Go Long Volatility (see VIX Chart), especially on 100 point plus sell-off days:: VXX, TVIX, VXZ, VIXY
  10. If you just have to have money in the market, then defensive stocks like: KFT, MO, PG
  11. Also, dividend stocks fare better in defensive markets: T, VZ, JNJ, MCD, KO, PEP, GSK, KMB, SYY, MRK, ABT, LLY, BMY, PFE, RTN

Conservative Strategy - Park in Money Market & Re-enter

I don`t recommend trying to get defensive as even your dividend stocks get hit during a prolonged 20% correction like we had last summer starting in late April, and eventually scarring policy makers into putting together another stimulus package to avoid a potential double dip recession.

The conservative investor should just go to cash in the form of some kind of money market fund, lock in some nice gains from this Bernanke-created Asset Inflation Program, wait for the substantial summer sell-off, and when it appears the selling has subsided, then get back into the market.

The critics are right that you can never perfectly time the market, but getting the bulk of moves is what is important, so you miss a few exact tops and bottoms. But you can take profits after considerable run-ups when reasons for the run-ups change, protect capital, and plan to re-enter, once the new levels of life without QE2 are established after the correction. A good ballpark number would be 20% from current levels.

Buy and Hold - Dead For A Decade

The alternative, to just keep your money in the market at all times, is an unattractive option in this era as the ten-year returns for just staying pat is basically flat to negative depending upon exact comparison points. In short, the buy-and-hold strategy has been dead for at least 10 years (see S&P 500 chart); you have to try your best to time markets these days.

Era of Trading & Profit Taking

We are in the era of trading, firms go bankrupt, companies get kicked out of indexes. We live in a volatile world where the value of assets is constantly changing, asset prices go up and down, and investors need to constantly analyze their portfolio, and the landscape surrounding their portfolio, to assess whether changes in the environment could positively or negatively affect their positions. Just keep in mind another old Wall Street adage: "No one ever went broke taking a profit" even if sometimes it is a little too soon.

QE3 Unlikely - Leading To A Massive Deflate

Make no mistake, there will be no QE3 anytime soon with gasoline prices and inflation concerns bubbling everywhere. The Fed`s hands are tied with this one, they will be lucky to get through the rest of QE2, (have you seen silver prices lately?). So, the inevitable selloff is just around the corner, and it will be a massive downturn in all assets that were inflated.

Remember, that was the goal of the Fed: to inflate assets. Well, once the stimulus is taken away, the assets start to deflate, and throw in some profit taking, new found short enthusiasm, and no more Bernanke put to embolden dip buyers, and voila! you get a sustained correction.

Juicing by QE2

Don't listen to those pundits who say the market will be fine without QE2 stimulus, that we might only get a minor correction of 2-3% this summer. I have watched markets come and go, and there has been a night-and-day difference in the way assets traded before QE2 and how they are trading currently.

One thing is for sure: the markets are trading 'artificially', where the same news about China tightening, or a European downgrade, natural disaster, or poor economic report is ignored and quickly discounted. The reason is that there is this massive injection of stimulus occurring every month to 'artificially' prop up asset prices.

Coming Soon - The Anti-Steroid

The best analogy I can give is the "Juicing Era" in baseball where all of a sudden a productive home run year would be 35-40 home runs for a player turn into 75 going over the fence for these same players.

We had skinny shortstops all the sudden hitting 25 home runs. Once they implemented a serious anti-steroid campaign, i.e., the stimulus was removed, all of a sudden the home run numbers went way down.

When you inject Fed monetary policy that is artificial, it gets in the way of normal, healthy legitimate two-sided price discovery of assets and markets. Once the 'artificial' is removed, markets will go back to normalized price discovery, and bad news really is bad news again, just as skinny shortstops go back to hitting 7 home runs per year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.