Sell in May?

If you have been in the market long enough, you have probably heard about seasonal patterns. Rooted in market conditions such as expectations versus reality during earnings season, quarter-end portfolio tweaking (i.e. window dressing) by fund managers and high profile index re-balancing. Not to mention external factors like tax loss selling, and general trends in business patterns related to production, advertising and release cycles.

There are no guarantees around seasonal patterns. In fact some argue that seasonal patterns are random and cannot be predicted. That any abnormally successful pattern (or strategy) will find its way into the mainstream, effectively squeezing out the historical advantage the pattern may have exhibited during previous market cycles. On the other hand, followers of anomalies will tell you that despite academic support for the efficient market hypothesis, seasonal patterns do exist and can be quite profitable. Not to come down on one side or the other, there are seasonal patterns worth considering. Particularly if you combine a seasonal pattern with supporting fundamentals.

A simply strategy that comes to mind is the one in which traders “sell in May and go away.” Historically, financial markets have had limited success during the summer months. And generally, September through October have not been favorable to stocks. As such, there is the axiom that one should exit in May and come back in time for a Christmas rally.

There are risks of course. Transaction costs can impact the success or failure of the strategy. Turning over your entire portfolio can be expensive, not to mention that potential tax drag if you are trading in non-registered accounts.

Implementing this strategy on a regular basis effectively eliminates half the dividends you would have collected. That’s can be significant, as longer term, dividend re-investment represents as much as 50% of your total return. Even more if you are looking at longer time frames. That’s a big risk for a strategy that recently, would not have provided any benefit to the investor.

So much for the history, what about the fundamentals? Most financial markets have been testing new highs, with limited success. Fresh weekly gains for the big indexes are increasingly flatter or non-existent as volume begins to fade. It could be a sign that the increasing concern about inflation, rising commodity prices, the removal of the US Fed’s quantitative easing program, and the decidedly uncertain future of the eurozone are starting to impact equity markets as the traditional summer doldrums approach. Those fundamentals lend support to the aforementioned seasonal pattern.

The trick is to play the pattern without setting off the risks. Rather than selling your shares, why not write covered calls on your equities. Covered calls that expire in October. That will allow you to generate cash flow through the summer and fall, without triggering tax on the disposition of your securities. You will still be collecting the dividends as well.

If you are concerned about the downside, you could opt to buy puts on the individual stocks. This will cause a cash outlay, but at current implied volatilities, put options are relatively inexpensive.

You could also take bearish positions on some of the more liquid Canadian indexes to hedge your portfolio. For example, bear call spreads on the iShares S&P/TSX 60 Index Fund. (TSX: XIU), iShares S&P/TSX Capped Composite Index Fund. (TSX: XIC), iShares S&P 500 Index Fund (CAD-hedged) (TSX: XSP).

And finally, longer-term investors could use the basic insurance function of the options market to protect established positions against steep downside moves by simply purchasing puts on the broad based indexes. That will provide some basic low cost protection in the event that investors this year “sell in May, go away, and don’t come back til Labour Day.”