FROM MY FRIEND DAVID:
April 11, 2014
“An expansion reaching its 59th month, as this one did in April, is anything but young. The average length of expansions, or the time between recessions, since World War II, is precisely 59 months. Curiously, none have lasted 59 months. Some expansions have been shorter and others have been longer. The past three expansions lasted an average of seven and a half years, while the longest expansion in recorded U.S. history lasted precisely 10 years. Expansions do not die of old age. Recessions typically come about due to a rapid unwinding of imbalances that have built up in the economy that typically follow some sort of monetary or fiscal policy mistake, or some sort of massive exogenous shock. Given the sluggish recovery in the labor market and housing sector, as well as the absence of inflationary pressures, the recovery still more closely resembles an economy in its adolescence…”
– Wells Fargo Securities, Economics Group, “Monthly Outlook,” April 9, 2014
The Federal Reserve (Fed) minutes are out. They affirm gradualism, patience, and offer guidance that the slowly paced tapering direction will continue for the rest of the year. Of course, everything is “data-dependent.” All indicators are that there will be no change in the Fed’s policy.
What does that mean for “Sell in May and go away” (SIMAGA)?
Many, many years of seasonality studies indicate a dangerous period of time from May through October. Some studies offer April as a starting point for trouble. Others suggest that the risky interval is between Memorial Day and Halloween. Whatever the case may be, SIMAGA musters considerable historical evidence to support the notion of a rocky period of five months encompassing the end of spring, the summer, and the beginning of autumn.
Many of those studies show that if you practiced SIMAGA on May 1 and went fishing until November 1 you were better off. If you bought the market on the November 1 and sold it on May 1 of the following year, you made an enormous amount of money. You were long stocks for somewhere around six months out of every year, and you were all in cash for the remaining portion. Lots of history supports SIMAGA.
Other studies show the reverse outcome if stocks were bought around May 1 and sold around November 1. If you had done that for the last century and stayed in cash from November 1 through the following May 1, you would have made virtually nothing over the entire century. May through October was mostly the worst time of the year to be invested.
We examined those historical periods. Then we also tested them against Fed policy. Add in what the Fed did, not what they said but what they did, and the dynamics change.
Roughly, the results are something like this. When the Fed is in a stimulative policy mode and is easing during the dangerous SIMAGA period, the effect of the easing neutralizes the seasonal impact on stock markets. Therefore, during those years in which the Fed’s policy was stimulative, SIMAGA did not apply. Other factors apply, like geopolitical risk, market valuation metrics, political cycles, earnings momentum and economic growth rates or inflation rates. The one factor that was neutralized was the seasonal factor. A stimulative Fed neutralizes SIMAGA.
When the Fed was neutral, a different result occurred. Markets struggled, but they did not get knocked hard on the head. A mild version of SIMAGA applied.
When the Fed was tightening during the spring and summer periods, it was best to avoid the stock market. Negative seasonal factors were exacerbated when the central bank was tightening policy. Don’t fight a tightening Fed in the summer time; that is when to follow SIMAGA.
What do we have today?
The Fed is stimulative. The reality is as simple as that, but perceptions are more complicated. Suppose the Fed had been at neutral initially, and then announced a program that over the next six months the Fed would buy federal mortgage-backed securities and Treasury securities and add them to its balance sheet. Suppose they announced purchases beginning at the rate of $55 billion and gradually trending down to $0 over the rest of the year. In this hypothetical model, markets would react to that announcement as a stimulative policy.
The only difference between what was just described and what is going to happen for the rest of this year is that the Fed is reducing the stimulus from a starting level of $85 billion per month, not raising it from a position of neutrality. The Fed is adding to the size of its balance sheet by outright purchases of government securities. Meanwhile, the inflation rate remains below the Fed’s target and has persisted there for a substantial period of time.
In our view, the stock market is neutrally priced. It reflects the continued application of very low interest rates, low inflation, and the likelihood of a continued gradual economic recovery. This is what Well Fargo called an “adolescent” recovery. That will lead to ongoing growth at a slow pace in the US.
At the same time, the current account and federal deficits are both narrowing. The twin deficits that used to haunt us by their enormity and persistence are both headed toward a more neutral and balanced place.
Think of it in the following way. External event balancing shows the current account deficit improving. Internal governmental fiscal policy is also headed toward balance. The shrinking federal deficit piles on top of well-behaved state and local government debt, deficit, spending, and restrictive policy. The Fed is maintaining gradualism, committing itself for the rest of this year and is being stimulative even as it heads toward neutral sometime at the end of 2014 into 2015.
All this says SIMAGA may be a mild effect this year. We may see a correction in the stock market. Three to five to seven percent corrections in the stock market can occur at any time, for any reason, and without warning. Such corrections tend to be attributed to whatever current event happens to be unfolding. Whether it is Vladimir Putin flexing Russian military might in Ukraine or an energy policy shift, it makes no difference. Markets react with single-digit corrections for any reason at any time.
Bear markets do not happen when the central bank is stimulative. Nor do they happen when the inflation rate is low, when interest rates are low, or when external shocks are contained (as with Vladimir Putin and the Ukraine crisis). They do happen when the economy faces a rising recession risk. Right now, the former seem to apply in the spring and summer of 2014.
We are holders of stocks in April 2014. We are finally seeing a long overdue correction. We do not believe it signals a new bear market. We believe that policy still favors rising asset prices and not SIMAGA.
Our new book is in preparation. It will be a second, expanded edition of the former best seller From Bear To Bull With ETFs. Stay tuned.
David R. Kotok, Chairman and Chief Investment Officer
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