Season your stock picking with risk rotation

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A stock market adage advises investors to "sell in May and go away." According to one strategist, that's only part of the story.

Sam Stovall, chief equity strategist at S&P's Capital IQ division in New York, says a pattern of rotating into less risky sectors every May and moving into more risky sectors every November can boost returns over simply holding the benchmark index for U.S. equities.

"You really could almost say: Six months of the year risk is on, six months of the year risk is off," Mr. Stovall said in an interview.

While Mr. Stovall's research has its critics, no one disputes that over the past few decades the worst six months to own stocks has been from May to October; the best period has been from November to April. Since the Second World War, the S&P 500 has risen 1.2 per cent on average during the six months that include summer, compared with 6.8 per cent during winter.

A habit of selling in May and coming back in November would protect an investor from the market's usual summer doldrums, but Mr. Stovall says a seasonal-rotation strategy would do even better.

He took the 10 industry groups in the S&P 500 and calculated each one's price change from May to October and from November to April since 1990. He found that holding the economically insensitive Consumer Staples and Health Care groups for the summer and rotating into the more volatile Materials and Industrials sectors for the winter would have led to compounded gains of 13.1 per cent on average each year, compared with 6.7 per cent for the S&P 500. The sector-rotation strategy beat the index 82 per cent of the time, he said.

Other researchers aren't so sure. Many strategies that look good on paper don't work in practice, warns Aswath Damodaran, professor of finance at New York University's Stern School of Business.

"Once you start micro-managing the data looking for patterns, you will find them simply because there is so much data that there have to be patterns," Prof. Damodaran said in an interview. "There's a very simple test for whether a strategy actually works. If it were this easy, then you should have a few mutual funds that are actually doing it and making money, right?"

Successful stock market strategies tend to be based upon robust logic, not just apparent patterns in data, said Stephen Foerster, professor of finance at the University of Western Ontario's Richard Ivey School of Business. "There's always the question of whether this is just happenstance, or if there is some reason why it might happen in the future,"

There is also the matter of tax and trading fees. Those transaction costs would take a bigger bite out the returns of the seasonal-rotation strategy than they would for a buy-and-hold investor. Mr. Stovall's research did not calculate the total impact of those expenses.

Investors who decide to try the S&P 500 sector rotation can do so through exchange-traded funds corresponding to the index's industry groups, Mr. Stovall said.

Another approach would be to pick specific stocks from each group. Examples of the November-April stocks include Monsanto Co. and Newmont Mining Corp. among the Materials group, and General Electric Co. and Caterpillar Inc. from the Industrials. The May to October portfolio could span stocks such as Johnson & Johnson and Wellpoint Inc. in the Health Care sector and Philip Morris International Inc. and Procter & Gamble Co. in the Consumer Staples area.

The six-month cycle has persisted over the years because of factors such as the timing of tax refunds and year-end bonuses, summer vacations, quarterly earnings reports and presidential elections every four years, Mr. Stovall said. He says these factors lead to regular seasonal swings in earnings and thus stock prices.

"I think [the strategy]works and there's reason behind it," Mr. Stovall said. He cautions that "no technique works all the time," but says "the biggest shortfall potential is people giving up on a technique."

Source: Globe Investor