What To Watch If A Correction Is Likely In May

market outlookMike Burnick: It’s a well worn adage on Wall Street to “sell in May and go away.” But is there any truth to this piece of trading conventional wisdom … or is it unwise advice? The answer depends a great deal on your chosen time frame.

In each of the past three years, advice to “sell in May” or thereabouts was spot on. In doing so, you would have avoided some short-term pain because stocks experienced spring-to-summer swoons in 2010, 2011, and again last year.

May marks the start of what has historically been the worst six-month period for stock returns. According to the venerable Stock Trader’s Almanac, over the past 63 years a hypothetical $10,000 investment in the Dow Jones Industrials from November through the end of April grew to $674,073. Meanwhile, the same amount invested only from May through October would have shown a loss of $1,105!

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Should you sell in May and go away?

But investing is never quite this simple. And the “Sell in May” strategy hasn’t always paid off with consistently good returns:

  • Between 1965 and 1984, selling in May proved correct most of the time as the S&P 500 declined in May fifteen out of twenty times …
  • From 1985 through 1997 however, May was the best month, gaining ground thirteen years in a row …
  • But since 1997 stocks returned to their losing ways in the month of May; down in 10 of 15 years, including dismal recent results.

If anything, the defining characteristic for the month of May is: Volatility!

Stocks have frequently posted extreme performance — both UP and DOWN — during May according to the folks at Bespoke Investment Group. This is especially true in recent years.

In three of the past four years we’ve witnessed May returns that rank both among the ten best and worst over the past 85 years. Extremely volatile monthly returns from one year to the next!

  • In 2010, the S&P 500 May decline of 8.2 percent ranks as the 5th worst on record …
  • Last year’s 6.3 percent swoon ranks as the 8th worst May ever  …
  • But in 2009 stocks posted a gain of 5.3 percent in May, the 8th best since 1928.

Here’s the takeaway: While there have been plenty of whipsaw moves in May over the years — both negative and positive — the average monthly decline of 2.6 percent in May since 2009 is enough to warrant caution at present.

That’s especially true because the rally since the November 2012 post-election low has not been interrupted by so much as a 5 percent correction. With the S&P 500 up 18 percent over this time frame, a short-term correction of 5 to 10 percent seems overdue.

Still, it’s not a good idea to simply sell your stock holdings based on nothing more than the turn of the calendar …

Here’s what I’m watching to tell me if a correction is likely in May 2013

Most of the major U.S. stock indexes recently hit new highs. But I’m keeping my eye on a potentially worrying divergence I have spotted in a few key indexes (see chart below).

Click for larger version

First, while the S&P 500 Index made new cycle highs in April, the small-cap Russell 2000 Index has not yet done so. The S&P list is dominated by large-cap stocks while the Russell 2000 is a broad-based stock index of many more small-cap stocks.

But the fact is that the Russell 2000 has also been a key leadership index during this bull market, soaring 172.8 percent since March, 2009, well ahead of the S&P 500 gain of 149.1 percent.

So the lack of participation in this broader list of stocks is a red-flag to me. After leading the charge to new highs at each turn of this bull market over the past four years, if small-caps can’t rally to new highs soon, it tells me investors are indeed growing cautious about stocks, and shunning the more volatile small-cap shares.

Second, in addition to the relative performance of the major stock indexes, traders and investors can learn a lot about the health of the market by watching the number of advancing versus declining stocks. This is a key measure of “market breadth” or the underlying strength among the individual stocks that make up the market.

Click for larger version

Once again, I’ve noticed a potentially negative divergence in recent weeks forming between the large and small caps. The chart above displays the number of advancing versus declining stocks on:

  • The New York Stock Exchange, which includes mostly large cap stocks, and …
  • Advancing vs. declining issues among the small cap Russell 2000 Index.

At a glance you can see that when the S&P 500 Index reached new highs recently, it was confirmed by new highs in the NYSE advance decline line (blue line), which likewise made a higher high. In other words, a majority of big cap stocks are following the index higher, a sign of healthy market internal strength.

On the other hand, the Russell 2000 Index advance decline line (green line) has failed to reach new highs since early March. In fact, until this week it has been making a series of lower lows. This tells me fewer and fewer small-cap stocks are participating on the upside, even as the major stock market indexes are rebounding to new highs.

Granted, these are only a couple indicators from the vast array of tools traders and investors rely upon to interpret the stock market’s next move. But whenever you see the Dow or S&P 500 making new highs, it also pays to look under the hood and see how the other, less glamorous, stock indexes are performing. Also, keep a watchful eye on the trend of advancing versus declining stocks as a good measure of market breadth.

It’s always important to have multiple analysis tools at your disposal, especially as we enter the merry — but sometimes treacherous — month of May.

Related: SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), SPDR S&P 500 ETF Trust (NYSEARCA:SPY).

Good investing,

Mike BurnickWritten By Mike Burnick From Money And Markets

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss  along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson. To avoid conflicts of interest, Weiss Research and its  staff  do not hold positions in companies recommended inMaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not  guaranteed. Performance returns cited are derived from our best  estimates but must be considered hypothetical in as much as we do not  track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene  Ceballo, Amber Dakar, Maryellen Murphy, Jennifer Newman-Amos, Adam  Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle  Zausnig.

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