STOCK MARKET WISDOM

SELL IN MAY AND NEVER CATCH A FALLING KNIFE – IS STOCK MARKET WISDOM CORRECT?
By Barbara Stadermann and Peter Brock, BeeWyzer GmbH

We are all familiar with stock market wisdom, as it is regularly quoted by financial journalists and stock market reporters. From time to time, articles appear that analytically verify or destroy such statements.

Stock market wisdom always reflects long established experience, so it should never be dismissed easily. But empirical knowledge is gained over long periods of time, and once the wisdom gets widely srpead, it sometimes reflects experiences from a context that no longer exists. And sometimes, the desire for a catchy line may have been the major inspiration – without material grounds.

From our point of view, stock market wisdom can be divided into three groups: timeless wisdom, partially correct wisdom, and the outdated one. 

The timeless category includes, for example, German “Hin und Her macht Taschen leer” (back and forth empties your pockets): a lot of trading activity empties your pocket, as it certainly will generate cost, whereas the performance contribution is unknown. Trading-oriented investment approaches such as day trading and trend-following models may be an exception – as long as the paradigms work. But most private investors, tend to be more long-term oriented, and for them this stock market wisdom is definitely useful. This is supported by the findings of various asset managers when analyzing their actual tactical transactions over longer periods of time in traditional portfolios: as a rule of thumb, between two and four transactions per year contribute positively to investment success, while more activity is neutral at best.

Partially correct pieces of wisdom can be found in the famous“Sell in May and go away – but remember to get back in September.” In fact, there is a seasonality to stock market performance in the manner described, which invites investors to take a break from the summer slump to the year-end rally. All studies confirm this pattern for a significant number of years, but the number of years that deviate from it is not small enough to stick to the rule. The saying originates from the London stock market of the 18th/19th century, when the upper class dominated trading and regularly caused a slowdown in stock market turnover and, in most cases, share prices during the summer break.

Holiday periods still exist today, but institutional investors are much less cyclical in their actions, and global ‘flows of funds’, i.e., the large global cash flows between world regions and asset classes, often have more impact than holiday-related seasonality. At the beginning of the year, however, there is regularly more fresh capital available that is looking for investment, and there are often year-end rallies targeting desired settlement prices.

However, for private investors with a long-term investment horizon, it is not worthwhile to fully ‘play’ this seasonality, i.e., to exit on a large scale in spring and re-enter in the fall. Because if the pattern does not materialize, investors may have to re-enter at higher prices than they have realized when selling.

A technical reduction of equity exposure using derivatives is, of course, possible, but with a future the economic result would be alike. By using options for hedging ‘at the market’, there may be significant insurance cost, whereas ‘out of the money’ the cost will be very limited, but it will only protect against a major price slump, not mild seasonal fluctuations.

We no longer follow famous German stock market guru Kostolany, who’s recipe was: ‘Buy stocks and take sleeping pills, wake up again after ten or twenty years and be happy’. In the decades after the World War II, the recipe was certainly successful. Now, however, we have a crash every 10 to 15 years, and the speed of cyclical changes in the real economy, on the financial markets, and in investor behavior is significantly greater and more complex than it was back then. For example, if a 40-year-old controller working for a big corporate invests her bonus of EUR 100,000 entirely in stock market ETFs to bump up her retirement money with a planned leave at the age of 60. But in year 15 a stock market crash kicks in, that makes prices plummet by 40%. The subsequent market recovery would have to be very strong in order to make up for the lost gains, but it is well possible to get back to positive performance figures. However, a market neither moving up nor down could also happen and spoil her targeted wealth level at retirement. Much more dangerous for her would be a crash after only a few years of investment, because then it would not only be a book loss of reduced gains, but the initial capital could be partially lost. By the time she retires, she may be able to make up for this and perhaps even return to profit, but an attractive overall return is unlikely. Simple math is worth to be looked at: if the capital of 100 falls by 50%, it is still worth 50. However, a 50% increase in price is not enough to return to the initial value of 100, as it will only lift you to 75% of the initial value. She would basically need an increase of a 100%. Psychologically, a 100% increase is quite a hurdle.

The three examples of stock market wisdom we have looked at confirm one thing: all this wisdom should be taken seriously, but but looked at critically. Was it ever valid? If so, is it still relevant today and valuable for my investmen? And how can this be efficiently implemented in my portfolio management?

Besides the lack of analytical knowledge and technical skills, however, it is often something else, that keeps us from being successful: In our brain patters (for example in the limbic system) there old evolutionary patterns that may have been helpful in the age of Fred Flintstone, but do not match the challenges of today’s financial markets. This is because some neurological conditioning for avoiding pain and generating positive dopamine releases was helpful then, but leads us to wrong decisions today. This is why ‘neurofinance’ has evolved as a discipline helping us to understand such misprogramming avoid decisions based upon it. This is why it is not enough to critically examine stock market wisdom: we also need to most critical of ourselves.