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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.

There are so many macro,“top-down” risks at present that even value investors, renowned for their “bottom-up” analysis of individual stocks, have started to worry about the big picture, macro stuff.

Let’s say you are a portfolio manager, and so far this year you are up 20 per cent (not an unrealistic number for many, especially with U.S. and Canadian stocks in record-breaking territory). What would you do to safeguard your Christmas bonus in light of all the macro areas of concern? Do you “sell in May and go away?"

Let me enumerate the macro risks, with data provided by Lountzis Asset Management LLC.

  • First, corporate bond issuance in the United States has sharply risen over the past few years from US$5-trillion in 2006 to US$9.1-trillion in 2018. The U.S. corporate debt as a percentage of GDP now stands at close to 47 per cent, a new record high versus the previous peak of 45 per cent in 2008. A lot of this debt is rated BBB, although more than 50 per cent of it would be rated as junk according to leading fixed-income investor Jeff Gundlach. Of concern is that most of this debt is maturing over the next five years.
  • Second, the leveraged loan market, which amounts to US$1.3-trillion according to a recent IMF report, is double what it was in 2008 and, more worrisome, 90 per cent of it is issued by non-banks with reduced investor-protection covenants.
  • Third, initial public offerings with negative earnings are higher now than even in 1999-2000.
  • Fourth, a significant reduction in primary dealer inventories of corporate bonds may lead to heightened liquidity issues for fixed income securities.
  • Fifth, rising global debt around the world has reached a new peak of US$244-trillion in 2018, from US$170-trillion in 2007.
  • Sixth, the world is flushed with liquidity, and capital flows are driving valuations irrespective of fundamentals. For example, many mergers today are taking place at 12 to 14 times EBITDA, or earnings before interest, taxes, depreciation and amortization, well above the typical 11 times EBITDA.
  • Seventh, all of the above risks are exaggerated by valuation metrics that point to a richly valued market. The S&P 500 trailing price-to-earnings ratio is currently 18.66, compared with a long-term average of 16.65. And the ratio of total U.S. stock market capitalization to GDP (a favourite metric of Warren Buffett’s) is at a record high.

When looking at portfolio managers’ performance, in light of the aforementioned risks, my crystal ball says that they will be heavy sellers of equities in a few weeks, leading once more to the pattern consistent with the “sell in May" adage, a seasonal pattern that rests on human psychology and the conflicts of interest of professional portfolio managers.

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.

Institutional investors are, on average, net buyers of risky securities early on in 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 lock in returns (and their Christmas bonus) by divesting from lesser known, risky stocks and replace them with well-known and less risky stocks or risk-free securities, such as government bonds. Such behaviour affects prices and security returns in a predictable way. Risky stocks and high-risk bonds are, on average, bid up early on in the year and down later on in the year, whereas low-risk stocks and risk-free bonds exhibit the opposite pattern – down early in the year and up later.

As arbitraging is taking place by those investors not bound by the restrictions or conflicts portfolio managers are facing, the pressure on stock and government bond 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 and the opposite effect for risk-free bonds.

Consistent with this seasonal pattern, my research has shown that the strongest quarter of the year for fund flows into stocks is the first quarter (January-March), while for government of Canada bonds, the strongest quarter of the year is the fourth quarter (October-December).

Such seasonal behaviour in security returns is difficult for the markets to fully eliminate for two reasons.

First, it is related to window-dressing and remuneration-motivated portfolio rebalancing by professional portfolio managers. Second, seasonality is not consistently observed every year. Unless we can anticipate seasonal behaviour on a consistent basis, market participants cannot fully arbitrage the seasonal behaviour of financial securities.

All this leads to my belief that we may have a strong “sell in May and go away effect” this year.

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