The annual seasonality buy signal has been triggered today.

I’m going to repeat some background about annual seasonality, then turn to the specifics of this particular signal. (If annual seasonality and MACD are old-hat to you, skip down to the “Recent Developments” heading below.)

As this Introduction to Annual Seasonality explains, the stock market tends to perform much better on average between November-April than it does between May-October. This is, of course, an average based on many years of observation, and any specific year can vary dramatically from that long-term trend. But it is a pattern that has persisted long enough, and across global markets as well as here in the U.S., so as to have attracted quite a bit of attention over the past two decades.

The basic idea of annual seasonality, then, is to sell stocks at the end of April and buy back in at the end of October. Taking this idea a step further, some researchers have shown that using a short-term timing signal, called MACD, to fine-tune the exact buying and selling points boosts the overall returns of utilizing the annual seasonality idea dramatically. SMI has been tracking this approach for the past decade or so, as explained in Adding MACD to Seasonality. This is the buy signal that has been triggered today.

It’s important to point out that annual seasonality has always been an optional refinement to SMI’s strategies. Most SMI readers have not utilized annual seasonality in building their long-term investment plans.

Recent developments

However, there have been two significant developments in recent years that now lead us to question whether following this seasonality pattern at all is worthwhile. First, our investigation of the impact of the election cycle on annual seasonality found that there is actually only one (out of four) unfavorable periods during which stocks have, on average, lost money. That is the May-October period leading up to the U.S. mid-term elections (the six month period we are just now exiting). There’s also only one (out of four) favorable period that is substantially better than the others (though the favorable periods of all four years have done well). Translation: based on annual seasonality, as viewed through this election cycle lens, there’s really only one six-month period out of every four years when you’d want to do anything other than own stocks.

Given that, even those who want to apply annual seasonality as part of their investing plan would have a compelling case to only alter their base asset allocation during the unfavorable period of each mid-term election year (and possibly the following favorable period, which we are about to enter — see the charts in the previous link which show this quite vividly).

The second significant development and reason to question the value of continuing to apply annual seasonality signals stems from our recent Dynamic Asset Allocation research. This new strategy already has a timing element built into it that triggers changes between six asset classes at any time during the year, irrespective of the annual seasonality cycle.

When owning stocks while applying annual seasonality is compared to simply owning stocks year-round, it’s easy to make an argument in favor of incorporating the annual seasonality modification. However, when comparing the relatively blunt-instrument approach of annual seasonality to the more specific signals generated by Dynamic Asset Allocation, the results aren’t even close. Dynamic Asset Allocation has provided much better signals of when to be invested in stocks and when to be out of them than annual seasonality.

We haven’t done exhaustive research on this, and naturally this can get fairly complicated if you start trying to go back and use the (better) MACD entry/exit dates. But a quick analysis we did last year indicated that over the prior two dozen years, using DAA would have produced more than triple the returns of applying simple annual seasonality to stocks. I expect the MACD modification would have narrowed that gap considerably. But it seems pretty clear that DAA is likely to give substantially better cues on when to enter and exit stocks than annual seasonality.

In some respects, this is an unfair comparison. Annual seasonality was never held out as a fine-tuned scalpel. It’s a blunt, simple device to improve on buy-and-hold stock market investing. DAA is purposely designed to give us more specific signals and it requires a lot more — someone has to calculate and track the momentum scores and potentially alter their allocation every single month instead of just twice a year.

But for the SMI reader, the issue is quite a bit simpler. The DAA information is available to you every month in a very simple to obtain format (just sign up for e-mail updates or visit this DAA page at the end of each month). Given that these signals seem better than annual seasonality’s, and they are so easy for SMI readers to obtain, it’s hard to imagine why someone would continue to use the blunt instrument approach of annual seasonality any longer.

This is a good illustration of DAA superseding some of our past advanced strategies. Annual seasonality was helpful until we found something better. Now that we have, we encourage you to use it instead.

We’ll continue to report on the annual seasonality timing signals, as we know there are readers who use it within their 401(k) accounts where DAA really isn’t an option. But hopefully we’ve illustrated why, for most readers, there are better options than annual seasonality for adjusting risk.

Note to Sector Rotation investors: If you pared back your Sector Rotation holdings based on our warning last May, you may want to wait until the end of the month to raise those holdings again. That’s because our current SR fund is in danger of being replaced. With 10 days left in the month and the market rallying, it may regain the top quartile and be retained. But I wouldn’t feel comfortable buying more of it myself today, so it may be wise to wait and see where things stand at the end of the month.