Sell in May?

Key Points
  • U.S. equities have pulled back after stalling around record highs. We believe that a pullback is healthy and could have further to go, but would never suggest an all-or-nothing strategy like “sell in May and go away”.

  • Trade uncertainty jumped back into the headlines with threats of additional tariffs coming alongside worsening prospects of a China/U.S. deal. Earnings season was mostly better than low expectations, but still only roughly flat in year/year growth. The economy continues to look fairly solid, although there are some cracks under the surface that raise some concerns.

  • It’s not just the United States that suffers from the trade war; however lower correlations among major global asset classes bolster the case for diversification.

“If your friend jumped off a bridge, would you go ahead and do that too?”
― Moms everywhere

Follow the crowd?

In honor of Mother’s Day, we weigh the above advice against the old Wall Street adage coined by Liz Ann’s first boss/mentor Marty Zweig: “The trend is your friend.” For long-time readers of this publication, it won’t surprise you that we side with mom—keeping with your long-term plan and maintaining a diversified portfolio. We would also add another long-time Wall Street adage in there: “Bulls make money, bears make money, pigs get slaughtered.” If you have gains after this recent rally that have resulted in the equity portion of your stock portfolio moving out of your long-term strategic comfort zone, taking profits may be prudent. As seen in the past week, direction and momentum can both change quickly.

Stocks rebounded from the “near bear market” low in late December, but stalled as new records were set; before pulling back this week as trade tensions with China ratcheted up. We wouldn’t mind seeing the pullback pick up a bit of steam in the interest of bringing in both sentiment and valuations, which had gotten stretched recently. We have no special or unique insight into the trade discussions, and there is a chance that the dispute could escalate and be a bigger drag on both stocks and the economy—bolstering further the case for diversification across and within asset classes (more on the trade dispute below).

Sentiment had moved further into the extreme optimistic territory according to the Ned Davis Research Crowd Sentiment Poll, typically a contrarian indicator at extremes (see first chart below). In addition, SentimenTrader’s so-called “Smart Money” Confidence (the non-contrarian indicator) had moved to historically-low levels; while the so-called “Dumb Money” Confidence (the contrarian indicator) had moved to extreme optimism (see second chart below), although the recent pullback has dented both of those measures.

Sentiment still overly optimistic

Ned Davis Crowd Sentiment PollSmart Money versus Dumb Money

Additionally, there may be additional selling pressure as we enter a historically weaker time of the year—promoted by the “sell in May” adage. We can’t deny that there is much truth in that saying, but we would never promote an all-or-nothing trading strategy based on the calendar. According to Bespoke Investment Group, since its inception in 1928 (through 2018), if you only owned the S&P 500 between November and April, your return would have been significantly higher than if you only owned it between May and October. You can see the various comparisons by time frame:

SP 500 returns

Past performance is no guarantee of future results.

As mentioned, investor sentiment has gotten extended, but it doesn’t appear that investors are rushing to put money into stocks, which would raise the threat of a “melt-up.” Strategas reports that eight out of 11 sector ETFs (Exchange Traded Funds) have actually seen outflows year-to-date, with the major exception being Communications Services (on which we have an “underperform” rating—see Schwab Sector Views for more.)

The first four months of the year were positive for the S&P 500; which, according to Strategas Research, has happened 15 times since 1950. Although past performance is no guarantee of future results; the good news is that in the remaining eight months of the year, the average gain was 10.0%. Importantly though, there was some interim drama, with the average drawdown during those years being -8.1%.

Where does that leave us? We believe a larger pullback would help ease both sentiment and valuation excesses. But we also believe we are late in the economic cycle and that recession risk is rising. If last year’s near-bear market was not a warning sign of a near-term recession, U.S. stocks are likely to resume their rally. However, if the yield curve were to invert again, a trade deal to fall apart and/or economic data were to continue to disappoint, a recession might begin sooner than the consensus believes; which would be a risk for stocks. For now, we remain “neutral” on U.S. equities, which means we are recommending investors remain at their long-term strategic allocation to stocks, without letting rallies get investors “over their skis.”