By: Tim Fortier — April 28, 2021
Sell in May? No Way!
In fact, Chris Rowe just wrote a great piece about this very phenomenon ("Technical Tuesday with Chris Rowe - Don’t “Go Away in May” -- Just Tilt the Scales Your Way.")
You can click here in case you missed it.
Chris concluded his discussion by saying...
"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."
Today I'm going to take that idea and run with it a bit...
The concept is based on real-world examples of how the stock market tends to underperform during the period between May and October.
Since 1945, the S&P 500 has gained an average of about 2% from May through October. That compares with a roughly 6% average gain from November through April.
More recently (since 1990) the average gain for the May -- October period has been about 3%, and the average gain for the November -- April period has been about 7%.
However, blindly following the strategy in recent years would have caused investors to miss some large gains.
Last year alone, during this seasonal period, the market posted some significant gains with the Nasdaq 100 up 27.15% and the S&P 500 up nearly 17%.
Would you really want to miss out on these kinds of returns?
What if you could invest in the strongest stocks no matter what the time of year? And even better, never worry about the missed opportunity cost of being out of the market during strong periods.
That's what we're going to talk about today.
A Strategy for All Seasons
I love strategies based on relative strength because relative strength always tells us what is working now. Not to oversimplify investing, but really, if you make a habit of consistently owning what is strong and avoiding what is weak... you cannot help but grow your wealth.
So here is my premise for the strategy I now want to share with you. What if, instead of avoiding the market during May-November, we simply always buy the strongest stock?
In fact, let's do this year-round.
For my starting universe, I am going to use the S&P 100. This index is a subset of the S&P 500 and represents some of the largest companies in America.
I will use two rules.
Rule # 1 - I will buy and hold the single stock displaying the best performance over the previous six months. I will buy this stock on the first trading day of each month. At the end of the month, I will run the analysis and rinse and repeat.
The premise behind this is that what has been strong often stays strong.
Now... if you're not careful, owning a single stock can subject your portfolio to some wicked volatility. To compensate for this I use a second rule.
Rule #2 - I will target the volatility of the single stock portfolio to 15%... the same volatility level as the wider market.
Since volatility is generally negatively correlated with returns, the position size of the security is reduced to match the target volatility. The end result is that, often, a varying percentage of the portfolio will also be holding cash.
The Results -- Time Frame: 12/31/2009 to 04/27/2021
As you can see in the image above, the strategy produces a compound annual return of 28.2% versus 14.6% for the S&P (SPY).
Overall, the strategy outperforms the S&P 500 about 68% of the months with the median winning period returning 3.08% and the median losing period showing a loss of -2.42%.
This results in an expected return of 1.32% a month... regardless of the seasonality factor.
Overall, the method has produced $16.52 for every dollar invested vs. $4.68 for the S&P 500... and with less risk, as measured by the higher Sharpe ratio and the lower maximum drawdown, which you can see in the image above.
For all of 2020 the model held Tesla (TSLA) along with varying amounts of cash. The model shifted to General Electric (GE) in February of this year and if we were to rebalance today, the model would hold a 45% position in Wells Fargo (WFC) and a 55% position in cash.
It's worth acknowledging that these types of strategies may only be suitable for active investors and investors. So you need to consider it within the context of a diversified portfolio that reflects your time horizon, risk tolerance, and financial situation.
My real point here is to urge you to explore the many types of alternative strategies beyond traditional buy and hold approaches.
As Chris discussed in his article, a strategy that combines both relative strength and size factors in addition to seasonal factors may also provide a market-beating edge.
Thanks for reading!
Until next time,