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Why value investors shouldn't dismiss 'sell in May and go away' strategy

Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

The stock market has its seasons. Bears come out in the summer and party in the fall while bulls start their run in the winter and plow on into the spring. It's an ebb and flow that can impact index investors and value investors alike.

The market's seasonal pattern was discovered a long time ago. Investors were told to "sell in May and go away" in a 1935 article in the Financial Times, which referred to the rule of thumb as being an ancient piece of advice even then.

More specifically, the idea is to stay out of the stock market for six months from May through to the end of October. Ben Jacobsen and Cherry Zhang of Massey University, New Zealand, published an extensive study of market seasonality in a 2012 paper called The Halloween Indicator: Everywhere and All the Time.

They looked at data from 108 of the world's stock markets and from 1919 to 2011. Stocks gained an average of 4.53 percentage points more in the six months starting in November than in the six months starting in May. The markets generated a small average loss of 0.18 per cent in the summer months and they gained 4.35 per cent in the winter months. (These figures do not include dividends.)

Kenneth French, distinguished professor of finance at Dartmouth College, compiles data that help to illuminate the market's seasonal effect on value investors. He tracks the performance of U.S. stocks based on a variety of metrics, including a value portfolio composed of the 10 per cent of stocks with the lowest price-to-earnings (P/E) ratios and a portfolio made up of stocks with the lowest price-to-book value (P/B)ratios. Each portfolio is updated annually to ensure it continues to hold low-ratio stocks and is weighted by market capitalization, which means it favours large stocks over small stocks.

The two value portfolios beat the market from July, 1951, through to the end of 2015 with the low-P/E portfolio gaining 16 per cent annually and the low-P/B portfolio climbing 14.5 per cent annually. The S&P 500 gained an average of 10.9 per cent annually over the same period. (These figures, and the following ones, include reinvested dividends.)

Seasonal investors who opted for U.S. government bonds from May through October and moved into stocks from November through April fared better than their buy-and-hold counterparts. Those who invested in the S&P 500 for half the year gained an average of 11.7 per cent annually from July, 1951, through 2015. The strategy saw the low-P/E portfolio gain an average of 16.5 per cent annually and the low-P/B portfolio climb 17.3 per cent annually.

But the months of August, September, and October provided some of the worst returns for the S&P 500 and the two value portfolios. Instead of staying out of stocks for half the year, investors might think about fleeing stocks for those three months.

Doing so would have yielded S&P 500 investors with average annual returns of 12.3 per cent. The low-P/E portfolio gained an average of 17.8 per cent annually by hiding in bonds from August through October and the low-P/B portfolio fared just a bit better with returns of 17.9 per cent.

Naturally, a few caveats are in order. Seasonality comes with more than a whiff of data mining. That is, there is a very real risk that past return patterns will not persist in the future. It is also important to point out that the method has suffered from more than a few off periods in the past.

I hasten to add that investors who trade regularly should keep a close eye on commissions, taxes, and other trading-related costs. A modest expected return advantage might not be worth chasing depending on the costs involved.

That said, value investors often give seasonality short shrift. It deserves more consideration by those who can trade efficiently.

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