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:

 

Current Value of $1,000 Invested in Small-Cap Stocks, Beginning on April 30, 1950*

Sell in May, buy back in October** $761,668
Buy in May, sell in October $1,859

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about examining seasonal switching strategies, I think it's worth making an additional assumption: Money that is withdrawn from the stock market isn't stuffed under the mattress; instead, it earns the risk-free rate on short-maturity Treasury bills until it's reinvested in stocks.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:

 

Small-Cap Stocks: Annualized Return (incl. dividends)

April 30, 1926 to April 30, 2012

Sell in May, buy back in October 11.1%
Buy in May, sell in October 4.5%
Buy-and-hold 12.2%

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:

 

Sell in May, Buy Back in October

Buy-and-Hold

Trailing 10-year period* 9.4% 7.7%
Trailing 20-year period* 11.4% 11.6%
Trailing 30-year period* 12.5% 12.1%

*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."

Fool contributor Alex Dumortier holds no position in any company mentioned. You can follow him on Twitter. Click here to see his holdings and a short bio. Motley Fool newsletter services have recommended shorting iShares Russell 2000 Index. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (8) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 11, 2012, at 5:44 PM, Mega wrote:

    "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."

    OK, you proved one particular calendar strategy hasn't been effective. That certainly doesn't prove that all calendar strategies haven't been effective.

    If you used two balanced stock-bond strategies for October-May and May-October (say 90-10 and 60-40), I think it would beat 100% equities, especially on a risk-weighted basis. Maybe enough to overcome transaction costs and taxes.

  • Report this Comment On May 11, 2012, at 6:00 PM, TMFAleph1 wrote:

    <<If you used two balanced stock-bond strategies for October-May and May-October (say 90-10 and 60-40), I think it would beat 100% equities, especially on a risk-weighted basis.>>

    Over what period? Are you suggesting that this is a superior strategy going forward or are you simply observing that this strategy outperformed a pure equity portfolio over the past 10 years?

    Either way, multi-asset strategies are outside the context of the discussion which pertains only to the equity portion of your portfolio. You're probably going to counter that T-bills are a different asset class, but the focus here is on assessing a market timing strategy for equities.

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  • Report this Comment On May 11, 2012, at 8:00 PM, Mega wrote:

    Yes, multi-asset strategies and risk-weighted return are outside the assumptions you make in the article. I would not say it is outside the context of the discussion, since we are discussing it.

    On a risk-weighted basis, I think reducing (but not eliminating) equity weight in the summer has worked and will continue to work.

    Calendar effects are not just a data artifact, they are observed in markets all over the world and driven by seasonal weather, cultural demand patterns, annual taxes, etc.

  • Report this Comment On May 11, 2012, at 8:10 PM, TMFAleph1 wrote:

    <<On a risk-weighted basis, I think reducing (but not eliminating) equity weight in the summer has worked and will continue to work.>>

    If you're just looking at a rotation in and out of cash, the Sharpe ratios don't support that, except perhaps over the last ten years, but that's a pretty small sample.

    <<Calendar effects are not just a data artifact, they are observed in markets all over the world and driven by seasonal weather, cultural demand patterns, annual taxes, etc.>>

    I certainly agree with you on this point, which is why I put quotes around "anomaly." As I wrote in the first article: "I think it's quite likely there is a seasonal effect to stock price appreciation that is more than simply a spurious historical observation."

  • Report this Comment On May 11, 2012, at 8:32 PM, feynmanshomeboy wrote:

    Statistics tells us that it is not surprising that there is a period of weeks or months that would underperform the S&P over 86 years. This anomaly has no predictive power. I believe it's covered in Damodaran's Investment Fables.

  • Report this Comment On May 11, 2012, at 9:13 PM, TMFAleph1 wrote:

    @feynmanshomeboy

    I don't think that's correct -- do you have a source to support your statements? As far as I could tell from my search, Damodaran does not cover this seasonal effect in Investment Fables.

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  • Report this Comment On May 12, 2012, at 7:48 PM, Mega wrote:

    I'm not talking about 100% rotation in and out of cash.

    The Sharpe ratio of a portfolio composed of 50% equities and 50% Treasuries is not equal to the average of the Sharpe ratios of 100% equities and 100% bonds.

  • Report this Comment On May 13, 2012, at 8:53 PM, TMFAleph1 wrote:

    @MegaShort

    Gotcha.

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