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By: Chris Rowe — May 1, 2015

Sell in May?

Imagine having a friend who you could call any time the stock market dipped.

This friend would calm you down and help you resist making the painful mistake of selling at a low.  He’s right almost every time, when he tells you to hold (or add to your position) because the stock market is oversold.

But there’s a caveat:  Your friend was usually right, as long as we were in a bull market.

I have two pieces of good news for you:

  1.  This friend does exist
  2. We are in a bull market

I’ve introduced you to this friend in the past.

He goes by the initials “R.S.I.”.  Below are two charts that show the Russell 2000 small cap index and its “Relative Strength Index” going back 6 years.

IWM - Russell 2000, Small-Caps
March 2012 - Today

(Click chart to enlarge)

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IWM - Russell 2000, Small-Caps
March 2009 - March 2012

(Click chart to enlarge)

2015-05-01_12-51-44

Readings in the RSI below 30 (notice the lower horizontal line) indicate a security or index is oversold.   It’s important to remember the adage “oversold doesn’t mean over”.

In other words, an oversold reading doesn’t mean you won’t endure another month (or more) of low prices.   And that’s the bad news.  But the good news is, oversold markets tend to be short lived.  If the RSI is down below 30, the time to sell has passed.  It might be time to sit back and weather the storm.  Tops take a long time to form while bottoms tend to form and snap back up pretty quickly.

But what about the other stock market adage:  "Sell in May, go away?"

Well, forget about it.

May was definitely a good time to buy in 3 of the last 6 years.  What about the other 3 years?

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May 2010 was when we saw the flash crash.  From the first day of the month, May 3, to May 6 the S&P 500 declined 6%, from closing price to closing price.  If you sold at the low of the day on May 6th then you sold when the decline from from May 3 was already as much as 11.4%. It happened in "a flash".

If you, instead, bought at that very moment, then you would have entered the stock market at one of the best prices of the entire year.

I don't have the stats but I'm taking a very educated guess when I say it's likely that most individual investors who sold in that May eventually regretted it.

If you sold on the first day of May in 2011 then you sold at the absolute top for that year.  But there were a number of indicators (including the RSI) that said it was time to exit the stock market.  Sentiment indicators put out a sell signal.  The NYSE Bullish Percent Index put in an overbought bearish signal.  I can go on and on.  The point is technical analysts not only were being told to get the heck out of Dodge, but consider taking bearish positions.

In May 2012, if you timed it perfectly, you may have been able to sell before a 9% decline in the S&P 500.  But, candidly, you almost certainly wouldn't have timed it perfectly.

The point is to not buy into the old adage too much.  The focus on a number of other indicators in conjunction with one another.  Most indicators that I focus on are saying the stock market is oversold but the momentum is to the downside.  This, to me, is not a good reason to sell, unless you are a short-term trader.   It makes more sense to hold positions and, if anything weather the storm.

I used the small-cap index as a reference in the two charts for two reasons:

  1. Small caps tend to lead.  So the fact we have seen a quick decline in the index is one "check" on the bearish side of the paper.  I want you to be mentally prepared for the media to possibly start talking about a dip.
  2. Small-cap growth has been the strongest area of the stock market.  (Small-cap value, not so much).  Both small-cap value and small-cap growth indices have seen their first "buy signal" from our good friend, RSI, after being in oversold territory.  Mid-cap growth, the other leader, is also in oversold territory.   On one hand, when leaders turn lower its time to take note as a bearish signal.  But on the other hand, have they officially "turned lower" yet?  I wouldn't say so.  And our trusty friend, the RSI, is once again saying its a bad time to sell.  So I'm certainly not a seller here.

I'm not saying we won't go lower.  I'm saying it's probably not a great time to sell.  And considering the market strength we have been seeing lately, I'm willing to stick around and duck-dive into the wave.

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