Sell In May: Volatility Isn't Going Away

Includes: HDV, IDV, IOO, IXP
by: Russ Koesterich, CFA

According to the old adage “Sell in May and go away,” investors are supposed to cash out their stock market positions in May and then take the traditionally poorer performing summer months off. It’s no wonder, then, that many investors are asking if it’s time to sell, a question all the more pertinent after last week’s losses.

In my opinion (which differs from that of some other market watchers), the answer is a qualified yes. I believe that investors should consider lightening up on certain positions and getting more defensive. But my belief is not based on the month of the year, but rather on current market volatility.

In fact, according to my team’s research, the summer seasonality myth doesn’t hold up. With the exception of September, which has historically been a month to avoid, no month shows a significant long-term performance bias, either positive or negative. In addition, higher average returns in January, March and April versus May or June likely don’t reflect anything other than chance and, as it turns out, July has generally been one of the better months for the markets.

I’m in favor of lightening up on equity exposure now because of my outlook for market volatility. Last February, I warned that equity market volatility appeared too low. At that time, the Chicago Board Options Exchange Volatility Index (VIX), an index otherwise known as the “fear gauge,” was around 17 to 18. After initially dipping, volatility did return in April, with the VIX climbing to 21 and the market correcting around 4%.

But now, even with last week’s spike in volatility, volatility once again appears too low, raising the likelihood for another jump in volatility and an accompanying modest pullback in equities.

As of late last week, the VIX was in the mid to high teens. However, two major drivers of market volatility - credit conditions and leading indicators - suggest that the VIX should now be in the low to mid 20s range, and not surprisingly it reached around 20 today.

From a credit conditions perspective, bond investors still appear somewhat more nervous than equity investors – traditionally a warning sign of upcoming volatility. Meanwhile, leading indicators suggest that economic conditions have not improved sufficiently to justify volatility at current low levels. In other words, while market conditions remain stable, they aren’t strong enough to justify volatility being below its long-term average.

So what will happen to the market if we do see the spike in volatility I expect? Historically, for every 1% increase in market volatility, stocks have lost around 15 basis points. This implies that if the VIX rises toward the mid 20s, we are likely to see a modest pullback in equities.

Investors looking to insulate portfolios in anticipation should consider adopting a more defensive stance through lowering exposure to technology equities, raising allocations to defensive sectors such as the global telecommunication sector and shifting styles toward global mega cap stocks and high dividend funds.

Following last Friday’s sell-off, global telecom, accessible through the iShares S&P Global Telecommunications Sector Index Fund (NYSEARCA:IXP), has outperformed the global market since the market’s April peak. Meanwhile, the iShares High Dividend Equity Fund (NYSEARCA:HDV) traded to a new high last week despite a pickup in market volatility. Other potential iShares solutions include the iShares Dow Jones International Select Dividend Index Fund (BATS:IDV) and the iShares S&P Global 100 Index Fund (NYSEARCA:IOO).

Disclosure: The author is long IXP, IDV and IOO

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments typically exhibit higher volatility. There is no guarantee that dividends will be paid.