Why 'Sell in May' principle just won't go away

For investors who are talking about the failure of the "sell in May" axiom this year, I would caution that here are still two traditionally volatile months to get through: September and October.

The "sell in May and go away" rule refers to the historical underperformance of stocks from May to October in relation to November to April. However, no one claimed that that May-to-October weakness occurs year-in and year-out, in the same way that stock markets do not always experience strength from November to April.

Historical evidence has shown that May to October represents a relatively weak semi-annual period for the stock market - on average, not every year. If an investor had followed the Wall Street axiom of "sell in May and go away" consistently, patiently and with discipline in the long run, he or she would have profited handsomely over the past 50 years.

While the average May-to-October stock market return over the past 50 years was about zero, May to October has not always been weak compared with November to April, a period over which the stock market experienced significant positive returns. In 29 of the past 50 years, the stock market experienced a positive May-to-October period. However, some of the largest declines in stocks happened in the May-to-October period, including the Great Depression of 1929, Black Friday in 1987, the long-term capital management debacle of 1998, the great recession and panic of 2008, and other large stock market declines.

This year's May-to-July stock market performance is unusual for its strength, which makes the continuity of such performance suspect. We're not at the end of this semi-annual period, so we're not out of the woods yet. Weak September and October returns could bring the May-to-October performance closer to average. My sense is that the stock market overreacted on the downside last year, fearing the end of the world. The May-to-October period was extremely weak by historical standards last year and this year the markets are catching up, so far producing a strong May-to-October period. But that doesn't mean the "sell in May and go away" effect has disappeared or its continuity will be questioned from now on.

To understand why stock markets experience seasonal strength in November to April, and relative weakness in May to October, you need to understand the factors driving this seasonality and to realize that those factors are not going away any time soon.

We normally talk about institutions making investment decisions. This is not true. It is individuals working for institutions who make those decisions. These people have their own psychology, over which they have little control, and their own agendas, which may differ from those of the institutions they work for. And these two factors will not go away. And neither will the "sell in May and go away" pattern.

Professional portfolio managers' own agendas and their efforts to maximize their own benefits lead them to rebalance portfolios and window dress in a predictable way throughout the year.

The high returns on risky securities around the turn of the year are caused by systematic shifts in the portfolio holdings of professional portfolio managers who rebalance their portfolios to affect performance-based remuneration. Institutional investors are net buyers of risky securities around the turn of the year when they are motivated to include less-known, high-risk securities in their portfolios and are trying to outperform benchmarks.

Later on in the year, portfolio managers (as they rebalance their portfolios) divest from lesser-known, risky stocks and replace them with well-known and less risky stocks or risk-free securities, such as government bonds. Toward the end of the year, they switch to stocks or securities they perceive to be less risky and more glamorous, and in so doing they spruce up their portfolios (that is, window dress) and at the same time lock in returns.

The excess demand or supply for risky stocks throughout the year bids the prices of these securities up or down. As arbitraging is taking place by those investors not bound by the restrictions or conflicts portfolio managers are facing, pressure on stock prices is spread over a few months, giving rise to stock market relative strength in November to April and relative weakness in the May-to-October period.

Moreover, as portfolio managers are exposed to the human behaviour of herding, they tend to move in tandem when they decide to buy or sell stocks; their effect on stock prices is pervasive and powerful, leading to the seasonal pattern of strength in stocks in November to April and weakness in May to October.

That explains why we've seen the largest stock market declines in the August-to-October period and the strongest stock market increases in the January-to-March period.

As portfolio managers have made substantial returns thus far in 2009, this may be time for them to lock in profits and rebalance their portfolios. And so, to those proclaiming the end of the "sell in May and go away" phenomenon, I say "it ain't over yet."

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.