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By: Chris Rowe — April 27, 2021

Technical Tuesday with Chris Rowe - Don’t “Go Away in May” -- Just Tilt the Scales Your Way

You know that age-old trader’s expression, “Sell in May and go away?”

It refers to the fact that the stock market tends to be much weaker during the warmer half of the year than it is in the colder half of the year. 

It’s a pretty basic stock market adage and it’s based on stock market behavior over the course of many decades. 

I’ve made a lot of money on seasonality cycles. But I never use them in isolation.

That’s because, at bottom, they are a form of “secondary analysis.” They can be used to support (or confirm) the merits of a trade idea.  

While important, we have to be careful not to rely too heavily on seasonal trends.  What if this summer happens to coincide with extremely bullish news that sends the market higher… this time?

Today I’ll show you a way to add another layer of probability in your favor, by using “relative strength analysis” on top of seasonal trends.  This will help you to determine which areas of the market you should be most focused on.  Besides, when it comes to money management, what’s much more important than market timing is your “allocation” (what you’re invested in).  

One of our readers recently described relative strength analysis as giving us market X-ray vision. 

Relative strength tells us what to buy by identifying the areas of the market with the potential to generate the biggest returns.

As an example, we can compare the strength of large-cap stocks versus (relative to) small-cap stocks. 

Hardly anyone likes it when the market crashes.  I hated even though I had bet on stocks declining and made an absolute killing, in both the crashes in 2008 and in 2020.  I just felt bad for everyone who didn’t know how to play it!

Here, let me show you.

We’re going to compare SPY (an ETF that tracks the S&P 500—which is made up of large-cap stocks) with IWM (an ETF that tracks the Russell 2000—which is filled with small-cap stocks).

Quick refresher...

A large-cap stock is any publicly traded company with a market capitalization (market valuation) of $10 billion or more. A small-cap stock is any publicly traded company with a market capitalization between roughly $300 million and $2 billion. A stock with 100 million shares outstanding, that trades at $5.00 per share, has a $500 million market cap.)

It’s important to note that these groups (large-caps and small-caps) tend to move in or out of favor, while the other group takes the lead.

Small-caps had been outperforming large-caps from October to March and since March the trend reversed to where the market has favored large-caps. I’m about to show you what usually happens next!

First I’ll give you two basic mental building blocks. Then I’ll layer relative strength on top of it, to show you which group tends to be in favor for each month of the year. 

The chart, below, illustrates the percentage of months since 2002 when the SPY (large-caps) closed higher than it opened. 

In other words, it shows how often the SPY (large-caps) finished a given month higher than it opened that month. It shows you this in terms of the percentage of time the month was a positive month (blue circle).

(Click any image to enlarge)

You can see that since 2002, the month of June has been tough. 

The SPY (large-cap stocks) closed the month out with a gain only 58% of the time. You can see that circled in blue, above. 

Now that we’ve covered the percentage of time the SPY closed higher, let’s see what the month’s return was, on average.  

Circled in red, you can see the SPY was down by 0.4%, on average, in June. Take a second to compare that to the other months. It’s the worst performing month and it’s one of 3 months that showed a decline, on average.  

The stock market has an upward bias over the long-term so any down month (on average) is a big deal.

Let’s keep digging... 

Take a look at the chart below. It’s the same chart except, in this case, we are studying the IWM Russell 2000 ETF (small-caps). 

Again, circled in blue you can see that 58% of the time the small-cap-focused IWM closed out the month of June higher than it opened it. That’s the same percentage as the SPY illustration we just reviewed. 

But what really stands out here is the fact that small-caps are UP, on average, in June. In fact, while large-caps (SPY) were down 0.4% on average, small-caps (IWM) was up 0.6%. That difference, between -0.4 and +0.6 is a full 1 point difference. 

Here’s where the rubber meets the road and gives us a clear picture of which months are better for large-caps vs. small caps.  

Take a look at the next chart comparing SPY to IWM since 2002.  

Cheat Note: When this chart looks “good” it means large-caps are in favor. When it looks “bad” it means small-caps are in favor. So if SPY is winning 60% of the time, it means IWM is losing 40% of the time.  

The month of June really stands out, doesn’t it? You can see that full 1-point difference that I mentioned.

Remember that June is just a little over a month away. That’s important to keep in mind. We’ll come back to it. 

Since 2002 the SPY has only outperformed IWM 21% of the time in the month of June. That means that 79% of the time, IWM (small-caps) outperformed SPY (large-caps).

That’s remarkable. But does that mean you should run out to buy small- caps? 

Well… Maybe. (Keep reading.)

Based on the seasonal trends, you have a higher probability of profiting if you stick with small-cap stocks.  

Remember what I said above, secondary analysis such as seasonal trends “supports the merits of a trade.”

Again, I’ve made a lot of money focusing on seasonality cycles. And again, they represent secondary analysis. 

Our primary focus here at True Market Insiders is on the endless revelations found by using relative strength analysis. It gives us a framework from which to view the market.  

And that framework lets us identify strength, and find the biggest winning trades.

Now that we’ve layered relative strength on top of seasonality, the next step would be to use relative strength studies to identify which sectors of the market are the strongest and then using relative strength studies to find the strongest stocks within those strong sectors.

So seasonality doesn’t mean running away in May. It does mean finding the means of tilting the scale your way. 

Thanks for reading,

Chris Rowe

Founder, True Market Insiders

 

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