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.

The Buzz: Are stocks in a correction or a bear market?

Sell in May and go away may seem like a silly Wall Street saying. But if you actually followed those words of wisdom, you'd be breathing a lot easier right now.

Stocks fell Monday as a better-than-expected jump in existing home sales in April was not enough to outweigh fears about the debt crisis in Europe. Tthe S&P 500 is now down about 9.5% in May.

So what now? Is the May malaise merely a long-awaited correction or the start of a new bear market that could last months or years? Is it time to buy in June and sing a happy tune?

Several market experts are guardedly optimistic that things won't get significantly worse. That's the good news.

"The most immediate concerns are transitory. They are important but they will get resolved soon," said David Joy, chief market strategist with Columbia Management in Boston. "It's important to have a well diversified portfolio and be prudent. But there's no need to exit the stock market."

Bruce McCain, chief investment strategist with Key Private Bank in Cleveland, added that he thinks there is little room left for stocks to fall from here. In fact, he said it's possible the market may have already hit bottom.

"This could be a surprisingly short correction," he said.

The bad news though is that the market may remain choppy for the foreseeable future.

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