For years, investors have puzzled over a striking stock market anomaly. Stocks tend to make their healthiest gains in the six months from November through April. In the other months, stocks tend not to do so well. Thus, the aphorism, "Sell in May and go away."
Since 1926, Standard & Poor's 500-stock index (.SPX) has returned an average of 13.4%, including dividends, from November through April. From May through October, the S&P 500 has returned just over half as much, averaging 6.8%. (All returns in this article are through April 30, 2017, unless otherwise noted.)
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The strategy, which I've written about before, has been noted by investors at least since 1935 and has been shown to work in 81 of 108 stock markets around the world.
A big drawback to Sell in May: What do you do with your money in the seasonally weak six months? After all, stocks, on average, do still rise in those months, just not as dramatically.
Now, there's another, more practical strategy. It involves investing in the S&P 500 for the seasonally weak six months and owning small-cap stocks the other half of the year. It turns out that the seasonal tendency of stocks to outperform in the winter and early spring is much stronger in small-company stocks than in large-company stocks.
Since 1926, an index of small-cap stocks tracked by the Leuthold Group, a Minneapolis investment research firm, has returned an average of 21.2% from November through April. That's a huge gain. What's more, small caps have averaged a puny 2.1% the other half of the year. (All the numbers in this article are courtesy of Leuthold. The small-cap returns are from Ibbotson, a Morningstar unit, through 1979; the Russell 2000 index thereafter.)
By investing in a small-cap index from November through April, then switching to the S&P, an investor would have earned an annualized 13.8% since 1926. By comparison, investing in a small-cap index for the full year returned an annualized 11.3%; the S&P returned an annualized 10.1%.
Such a switching strategy would have outperformed the S&P in 56 of the last 91 years. The average outperformance in the winning years works out to 12.3 percentage points, and the average underperformance in losing years is 7.0 percentage points. Last year, the strategy was up 15.4% versus 12.0% for the S&P.
But there's still a dilemma: I know that virtually no one will really implement the traditional Sell in May strategy. The same goes for the Switch in May strategy outlined in the last few paragraphs. Why? Let's face it: The anomaly makes no sense. It's as crazy as the old (and now failed) Super Bowl anomaly that called for a good year in stocks if a team from the old National Football League won. What's more, there are taxes and trading costs to consider.
"Fascinating," says Doug Ramsey, Leuthold's chief investment officer, of the switching strategy. "But not something we currently use for managing money."
Still, you can profit from this anomaly by tilting your portfolio more toward large caps during the seasonally weak months and more toward small caps during the seasonally strong months. That's easier to do in a retirement account where capital-gains taxes aren't an issue. Or, you can tweak your contributions to favor small caps in strong months, or your withdrawals to reduce large caps over the same period. That's something any investor can do.
But maybe not for long, says Ramsey: "By the time the behavioral-finance people figure out why it works, it'll probably disappear."