Sell in May, Buy in June?

by Chris Johnson and Jon Lewis 02.06.2010

We remain ready to add positions to this teetering market, but as the day-to-day tape sees little more than directionless volatility, the correct move has been to wait to see how the technical patterns work themselves out.

Given that the technical picture is more than likely to determine the next 5% to 10% move in stocks, to guess the resolution of these trends would be tantamount to betting on black or red on the roulette wheel in Vegas. It's simply a game of chance. We're not fans of playing that game with the market. We'd rather place bets when the odds are tilted in our favor. So let's look at how the odds are stacking up today.

Beyond uttering the words "sell in May," no one really talks about how the market tends to trade through the month of June. The table below displays the average monthly performance for the S&P 500 (SPX) for each month of the year, going back to 1950.

According to this data, May is notably weak with one of the lowest average monthly returns and one of the lowest win/loss percentages. This, of course, backs up the sell in May mantra that we typically hear investors chant through the month, but does it mean that there aren't any trading opportunities in the current month?

Just the contrary, the volatility picture has changed considerably as we're witnessing a CBOE Volatility Index (VIX) that is trading well above its averages, indicating that the fear priced into the current market landscape is closer to calling a short-term bottom in stocks than a top.

With the VIX in what we refer to as "transition mode," it is becoming clearer that the market is preparing for a 5% to 10% directional move, and the odds are favoring a rush higher in equity prices.

For now, those trading their own accounts need to maintain a vigilant eye on the potential reversal in the VIX. The 10-day moving average is the best way to confirm this reversal (red line in the chart below). This trendline is in the process of rolling over to begin a declining pattern.

According to our studies, such a reversal will lean the odds to an average of nearly 2:1 that we will see daily gains in the market over the next month, as long as this declining pattern stays intact. You won't find those types of odds in Vegas!

Our trading has been less active as this transition period has evolved, but we're preparing to set a number of leveraged positions in advance of what appears to be a short-term opportunity to grab some upside movement.