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strategy

Brian Jackson

Investors have no doubt already read stories on the "sell in May and go away" maxim, but with June nearly upon us, I'd like to offer my own thoughts on this effect.

To begin with, the "sell in May and go away" rule refers to the average historical underperformance of stocks from May to October in relation to November to April.

If an investor had followed the Wall Street axiom of "sell in May" consistently, patiently and with discipline in the long run, he or she would have profited handsomely over the past 60 years.

While the average May-to-October stock market return over the past 60 years was about zero, May to October has not always been weak compared with November to April, a period over which the stock market experienced significant positive returns. In 35 of the past 60 years, the stock market experienced a positive May-to-October period. However, some of the largest declines in stocks happened in the May-to-October period, including the Panic of 1907, the Great Depression of 1929, the Black Friday in 1987, the long-term capital management debacle of 1998, the Great Recession and panic of 2008, and other large stock market declines.

To understand why stock markets experience seasonal strength in November to April, and relative weakness in May to October, you need to understand the factors driving this seasonality and to realize that those factors are not going away any time soon.

We normally talk about institutions making investment decisions. This is not true. It is individuals working for institutions who make those decisions. These people have their own psychology, over which they have little control, and their own agendas, which may differ from those of the institutions they work for. And these two factors will not go away. And neither will the "sell in May and go away" pattern.

Professional portfolio managers' own agendas and their efforts to maximize their own benefits lead them to rebalance portfolios and window-dress in a predictable way throughout the year.

The high returns on risky securities around the turn of the year are caused by systematic shifts in the portfolio holdings of professional portfolio managers who rebalance their portfolios to affect performance-based remuneration (that is, their Christmas bonus). Institutional investors are net buyers of risky securities around the turn of the year when they are motivated to include less-known, high-risk securities in their portfolios and are trying to outperform benchmarks.

Later on in the year, portfolio managers (as they rebalance their portfolios) divest from lesser-known, risky stocks and replace them with well-known and less risky stocks or risk-free securities, such as government bonds. Toward the end of the year, they switch to stocks or securities they perceive to be less risky and more glamorous, and in so doing they spruce up their portfolios (that is, window-dress) and at the same time lock in returns.

The excess demand or supply for risky stocks throughout the year bids the prices of these securities up or down. As arbitraging is taking place by those investors not bound by the restrictions or conflicts portfolio managers are facing, pressure on stock prices is spread over a few months, giving rise to stock market relative strength in November to April and relative weakness in the May-to-October period.

Moreover, as portfolio managers are exposed to the human behaviour of herding, they tend to move in tandem when they decide to buy or sell stocks; their effect on stock prices is pervasive and powerful, leading to the seasonal pattern of strength in stocks in November to April and weakness in May to October.

As portfolio managers have not made substantial returns thus far in 2016, there will be no big profits lock in and little opportunity rebalance their portfolios – even though they may still choose to window-dress. And so, the "sell in May and go away" phenomenon may not hold this year.

So there you have it. You now at least have a theory of why the "sell in May and go away" phenomenon, on average, works.

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.

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