The Real Reason to Sell Small Caps in May

At the end of last month, I asked whether investors should sell in May, consistent with the old market adage that one should "sell in May and go away." Rather than rely on oral tradition or mysticism, I looked at the data: 86 years' worth of monthly stock and cash returns, in fact. The article was one of the most widely read I have ever written for The Motley Fool, so I have to assume people are interested in this topic. One of the questions I received in the comments section has motivated me to return to the same question, but this time we'll be scrutinizing small-cap stocks.

The numbers don't lie
The data commentators and analysts cite most often in support of a "sell in May" strategy is that of Ned Davis Research. As I mentioned in last week's article, one of the apparent shortcomings of their analysis of the S&P 500 is that they don't include dividends -- which matter a great deal. However, the results they publish for small-cap stocks do include them:

Source: Ned Davis Research. *At March 31, 2012, includes dividends. **Money is invested in stocks from Sept. 30 through April 30 annually, and is in cash (no yield) during all other periods.

Based on those numbers, "sell in May" looks like an absolute slam dunk. Still, if we're serious about examining seasonal switching strategies, I think it's worth making an additional assumption: Money that is withdrawn from the stock market isn't stuffed under the mattress; instead, it earns the risk-free rate on short-maturity Treasury bills until it's reinvested in stocks.

The numbers that matter
Under those guidelines, this is how "sell in May" stacks up against "buy in May" and "buy-and-hold" over the longest period for which I could obtain the data:

Source: Federal Reserve Bank of St. Louis, Ibbotson Associates, Russell Indexes, Standard & Poor's, author's calculations. The small-cap return series was spliced together from an Ibbotson Associates series (up to December 2005); thereafter, the series is based on the Russell 2000 Index (INDEX: ^RUT).

Buy-and-hold takes the crown -- as it did with the S&P 500 index -- with a better than 1 percentage point margin of outperformance. Still, readers were naturally curious to know how the strategies had performed over shorter, more recent periods. This is how the numbers pan out for small caps:

*At April 30, 2012.

The advantage of buy-and-hold over the more recent past is less certain and, in fact, "sell in May" has put up much better returns over the past 10 years. However, I would caution readers to be careful in interpreting these results.

When statistics and economics diverge
First, there is a big difference between statistically significant and economically significant. A seasonal switching strategy suffers tax and transaction costs that buy-and-hold doesn't. Over the trailing-30-year period, the 40 basis points of outperformance "sell in May" displays (12.5%-12.1% = 0.4%) could quickly evaporate once these costs are accounted for.

Second, although the "sell in May" strategy has decisively beaten buy-and-hold over the past 10 years, that period is far too short to try to extrapolate any lessons from that result. I agree with readers who remarked that the stock market has undergone massive changes over the past 30 years, but there is no way you should satisfy yourself with a 10-year sample to assess the merits of this strategy.

A seasonal anomaly...
Ned Davis Research's results are useful in highlighting a seasonal component to stock price appreciation: Statistically, stocks -- whether large caps or small caps -- have performed much better during the period October through April (autumn and winter, roughly speaking) than May through September (spring and summer). This "anomaly" is a conundrum if you're a strict believer in the efficient markets hypothesis, but as I think I've shown, it's far from clear that individual investors can gain any advantage from this observation.

...and a valuation anomaly
In other words, if you own the iShares Russell 2000 Index ETF (NYSE: IWM) or Vanguard Russell 2000 Index ETF (Nasdaq: VTWO), there is no need to liquidate your positions just because we've hit May. However, there is a genuine consideration that looks dissuasive as far as owning small caps as a sub-asset class: valuation. As of last Friday's close, the P/E10 of the Russell 2000 was 29.6; for reference, at the end of October 2007, it was 35.9 (the P/E10, which is sometimes referred to as the Shiller P/E, is based on trailing average real earnings over the past 10 years). Smart asset allocators want to be underweight overvalued assets, not the other way around. That goes for stock pickers, too, of course; if you're in that group, I recommend you get familiar with "The Stocks Only the Smartest Investors Are Buying."