Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: As we've discussed in a recent interview, November marks the start of what is known as the Best Six Months for the stock market. But really, a more accurate way to look at this period may be what you call, "the cyclical six." Can you tell us more about what that means?
Stovall: I first heard about the best six months of the year strategy from the Stock Trader's Almanac. I did my own analysis to make sure that I agreed with that statement, and sure enough, when you go back to 1945, the S&P 500 posted its strongest six-month price performance from October 31 through April 30 of each year. The average price change during this period on the S&P 500 is a gain of 6.8 percent, which is the strongest of any rolling six-month period. Also, the market rose in price 78 percent of the time, which is also the best frequency of advance. On the flipside, I found that May through October was the worst period for the market, gaining only 1.2 percent on average and posting the second-worst frequency of advance of only 63 percent.
Interestingly enough, when I looked at this a little deeper and split sector performances into two six-month periods, I found that the cyclical sectors did better in November through April. That's not surprising since if the market itself does well from November through April, then the cyclical sectors would be the ones in the leadership role. On the other hand, in May though October, the defensive sectors (Consumer Staples and Healthcare) were the best performers. That makes sense as well since investors that are nervous about stock market performance and focusing on capital preservation will gravitate toward those sectors where the demand for the products and services remain fairly static. From November through April is when the cyclical sectors do the best, hence I call that six month period in which those cyclical sectors perform best the "cyclical six."
EQ: So historically, if investors combined elements of the Sell in May rule with a sector rotation strategy, how would they have performed against the broader market?
Stovall: Starting back from April 30, 1990 through the end of October 2011, if an investor had equally invested 50 percent in Consumer Staples and 50 percent in Healthcare, from the beginning of May through the end of October, and then switched into the cyclical sectors of Industrials and Materials from November to April, and then rotated every six months between cyclical and defensive sectors, it would have provided a compound rate of growth of 13.1 percent as compared with a compound rate of growth of 6.7 percent for the S&P 500.
Of course, what worked in the past may not necessarily work again in the future. But, if the market exhibits this sense of cyclical dominance in performance from November through April, it would seem to me that the cyclical sectors do better in the winter, if you will, and the defensive sectors do better in the summer.
EQ: For investors looking to implement this strategy, do you think sector ETFs are the way to go or would you suggest screening for more specific companies?
Stovall: Investors certainly can screen for individual stocks to serve as proxies for the different sectors, but it would be just an awful lot easier if investors used sector ETFs.
For instance, an investor with $1,000 could start on Nov. 1, 2011, and employ this strategy by investing $500 into the Materials Select Sector SPDR (XLB) and then invest the other $500 into Industrial Select Sector SPDR (XLI) since Materials and Industrials are the two cyclical sectors that have performed best from November through April going back to 1990.
So by April 30, 2012, hopefully the total amount has gone up in price and the $1,000 is now worth $1,200. I use that number as an example simply because it's now easier to divide in half. The investor would sell their holdings in XLB and XLI and with the $1,200, they could invest equally by putting $600 into Consumer Staples Select Sector SPDR (XLP) and the other $600 in Health Care Select Sector SPDR (XLV). From there, they could just let it sit until the end of October when they would sell those two ETFs and buy again with 50-percent exposure into XLB and XLI. So investors would do this every six months, and that's pretty much it.
EQ: So for investors weighing the benefits and potential downsides to this strategy, what are some caveats or risks that they should understand before adopting this rotation strategy?
Stovall: Certainly, there are people that might think that this approach sounds cute or is an interesting example of data mining, and therefore might want to stay away from it because it's not something that uses the things that they learned in their CFA classes or investment courses.
My response would be that maybe that's why it continues to work, because nobody is trying to arbitrage a way for these outperformance statistics. But like with any strategy, no strategy works all the time. Indeed, this strategy underperformed the S&P 500 in 2003-04 as well as in 2004-05, indicating that no technique works all the time. So my advice to investors, however, is that if you are going to embrace a rules-based investment strategy, be willing to stick with the rules even if they underperform for one or two years at a time because, as I believe Murphy's Law dictates, the technique will start to work the day you give up on it.
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