Saturday, June 30, 2007

John Authers: Just take it easy over the big sell-off season

John Authers: Just take it easy over the big sell-off season
By John Authers
Copyright The Financial Times Limited 2007
Published: June 29 2007 16:04 | Last updated: June 29 2007 16:04

Timing the market is a mug’s game. The efficient markets hypothesis holds that it is impossible: markets always adjust to account for all known data.

In practice, of course, markets are not always efficient. But inefficiencies at the grand level of overall stock markets or asset classes are harder to spot than at the level of individual stocks. Market calls look like a bad gamble.

But they are a gamble that can make a lot of money. And several market-timing models signalled a risk of a sell-off earlier this month. Should they be taken seriously?

Several factors go into these models. First, the amount investors spent to protect themselves from equity market volatility, as measured by the Chicago Board Options Exchange’s Vix index, spiked to its highest level in months this week. That is a bad sign.

Then, credit spreads – the extra cost of borrowing for higher risk companies – have widened.

And trading in the Japanese yen suggests traders are growing nervous about the risky game of borrowing at low Japanese interest rates.

All suggest growing risk aversion. When sudden waves of risk aversion hit, markets are vulnerable.

A historical pattern might also come into play. Teun Draaisma, European equity strategist at Morgan Stanley, points out that stocks are less volatile in the first stage of a bull market, when returns are earned on the good value that stocks have come to represent. In the later stages of a bull market, returns are based on more optimistic multiples and hopes for economic growth, and things get much more volatile.

In US stocks, there were six separate “corrections” of 10 per cent or more in the three years leading up to the top of the internet boom in 2000. There has not been one single correction of this magnitude in the US since the current bull market started in late 2002 (although there was one correction this deep in Europe, which started in May last year).

It is logical to expect more sharp corrections as the bull market grows older.

Then there is seasonality. David Schwartz points out powerfully that it is always possible for patterns to recur over time by coincidence.

But the annoying old saw of the stock market that you should “sell in May and go away” turns out, quite remarkably, to have been a good strategy.

David Bowers of Absolute Strategy Research in London looked into the historical results from two seasonal patterns of investing. A strategy of being in stocks (the FTSE All-Share) from November to April each year since 1963, and in bonds from May to October, would have beaten the FTSE All-Share. Holding bonds from November to April and stocks from May to October would, on the other hand, have lost money in nominal terms.

Since 1997, the “Sell in May” strategy has gained 95 per cent, while the “Buy in May” strategy has lost 19 per cent. The All-Share is up 57 per cent. This is not due to a few one-off events. Over every three-year and five-year period since 1980, these results have held good. Selling in May always wins. This also holds true whether the money held out of the market is parked in bonds, or cash, or hidden under the mattress.

As for this year, the market in several countries peaked on June 1 – exactly when Draaisma of Morgan Stanley wrote what would be a highly-publicised note recommending that investors go tactically “neutral” on European stocks, to guard against a summer sell-off, and shift into cash (while staying underweight in bonds).

At the time of writing, all the major western indices were on course either to be flat or down for the month of June – apart from a few Asia-Pacific markets. Investors obviously started selling at the end of May.

There are a few good reasons why stocks should be seasonal. The oil price affects stocks, and it is justifiably seasonal. Traders, currently preoccupied by the state of oil inventories in the US, need to know the full impact of the summer driving season in the US and Europe, and they also need to know about the annual hurricane season.

Liquidity also helps to drive stock prices, as do deals. Both tend to go down during the summer months, when schools are on vacation and when fewer traders are at work.

With fewer deals to keep the market bubbling in the holiday season, summer drift is not surprising. The recent rise in bond yields, and the widening of credit spreads, make it harder to finance acquisitions and make a lull more likely.

Weather, too, can have an effect on trading activity. For example, the morning weather in Chicago can affect that day’s action in its futures markets.

But Bowers suggests not much weight should be put on this, as stocks in Australia also trade sideways from May to October – the Antipodean winter.

The efficient markets hypothesis says none of this need hold this year, because players in the market can see all these factors and position themselves accordingly. But the case for taking it easy over the summer is still tempting.


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