The first significant volatility the stock market has faced in months has finally pulled the trigger on the annual seasonality sell signal today. This signal had been getting close to being triggered in recent days, and today's action has pushed it decisively over the edge.
To avoid any confusion, I'm speaking of the MACD signal (read on if you don't know what that is), which gives us slightly different entry and exit points than the traditional "Sell in May and go away" dates.
As this old Introduction to Annual Seasonality article explains, the stock market has historically tended to perform much better on average between November-April than 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. (“Sell in May and go away.”) SMI makes a further refinement to this basic seasonality approach by looking to "fine tune" the buy and sell signals based on a mechanical indicator called MACD.
Questioning the value of investing seasonality
However, there have been two significant developments in recent years that now lead us to question whether acting based on this seasonality signal information is the best approach. 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 (which last happened in 2014 and will happen again in 2018). The other three unfavorable periods, including the one we’re entering this year, have still been positive on average. Which leads one to question the wisdom of making significant changes to an otherwise well-designed portfolio during these other unfavorable periods.
In other words, 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 mid-term election year unfavorable period (and potentially the following favorable period, which has been abnormally strong, on average). The other three years, they would leave their allocations alone and ignore annual seasonality.
Improving on investing seasonality
The second reason to question the value of continuing to apply annual seasonality signals stems from the research we did that led us to launch our Dynamic Asset Allocation (DAA) strategy in 2013. This strategy has a timing element built into it that triggers changes between six asset classes all year long, 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.
How much better have DAA's signals been than annual seasonality's? We haven’t done exhaustive research on this, but a quick analysis done a few years ago indicated that over the prior two dozen years, using DAA would have produced better than triple the returns of applying simple annual seasonality to stocks. (That's using the standard April 30 and October 31 exit and entry points, not the MACD refinement.)
To be fair, no one ever claimed annual seasonality was a finely-tuned timing instrument. 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 holdings every single month instead of just twice a year.
But for the SMI member, the issue is quite a bit simpler. The DAA information is available every month in a very simple format. Given that these signals have been significantly 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.
Unless, of course, they're applying it to an account where using DAA isn't feasible. It's primarily for these readers that we continue to report on the seasonality MACD buy and sell signals. But for everyone else, we believe DAA offers better timing cues than annual seasonality.
If you do use investing seasonality
Even before the creation of DAA, SMI always maintained that annual seasonality should represent a relatively small refinement to your existing long-term plan, rather than being used as an "all in" vs. "all out" tool. We've seen annual seasonality be painfully out of synch with the market at times. As such, we've recommended making measured changes to your stock/bond allocation, if you choose to implement annual seasonality at all.
For example, someone who would otherwise have a 70/30 stock/bond allocation might choose to lower that to 60/40 during the unfavorable summer period, then raise it to 80/20 during the favorable winter period. That would give them an average allocation close to their ideal, optimized to correspond with the market's long-term statistical pattern. (Some readers have found that using automated versions of the strategies involved makes this semi-annual switching process easier.)
Another idea that has been popular with readers in the past is to switch a portion of their portfolio back and forth between a more aggressive strategy, like Upgrading, and a more conservative one, like DAA. Along those same lines, some might choose to pare back their Sector Rotation allocation during an unfavorable period such as this.
However you approach it, keep in mind this often-overlooked point about annual seasonality: the main objective of annual seasonality is not to improve returns. Rather, the primary objective of annual seasonality is to reduce risk. The data indicate that the overall returns of a portfolio invested in stocks only during the favorable period each year (and in bonds the rest of the year) has produced very similar total returns to a portfolio that was fully invested in stocks year-round.
Confused? Ask a question and we'll try to clarify anything that isn't clear. But bottom-line, if you don't have a compelling reason and desire to use annual seasonality, you can safely skip right by it and pretend it doesn't even exist.