Sell in May, and Go Away & the U.S. Dollar

  on May 09 2012 3:11 AM

The last two years selling in May and going away, as the old Wall Street saying goes, worked pretty well in the U.S. stock market.  It worked even better in 2008, and then again for a month or so in 2009, but then you would have been left in the dust - see Figure 1. When it comes to speculating on market movement though, I don't think God above knows for certain what will happen.  

Figure
Figure 1. Weekly Chart of S&P 500 Stock Index

What makes market movement so unpredictable is market corrections. Those times when price moves counter to the long term trend. Charles Dow's described corrections as a potential market turn, where we don't know when it will occur, nor how long it will last. The one aspect of markets which does give a degree of predictability is price pattern, i.e. technical analysis, and the understanding that what we see on the chart is a reflection of current fundamental developments.

What is cool about technical analysis is what the geometry of the individual chart is telling us about that market. For example the U.S. stock market - seen in Figure 1 -is showing us a pattern of impulse rallies from late Fall into Spring, followed by a summer (into fall) sell-off, or correction.  As long as a correction ends at a higher low point than the previous correction the market is in a bull phase. What is also cool about technical analysis is the study of correlations between related markets, and what that is telling us about the business cycle and current Keynesian policies. For example while the stock market has seen several bull phases over the last couple of years, so have bonds.  From an economic standpoint this is not a healthy long-term development. Because as bonds move higher interest rates move lower. And as interest-rates move lower savings rates shrink and people look for higher yields elsewhere.  Because of shrinking yields for savers stocks, currencies, and commodities become more attractive based on demand from investors in search of a higher yield. Investors today have the choice of a low yield, or a higher risk of loss. This is what traders and investors have taken to calling the risk trade, because so many market groups are correlated to each other.  There is little yield left so an investor is either risk on (long stock, currencies or commodities) or risk off (long cash). The only market moving opposite of the risk trade is the U.S. Dollar. When global economic news is good, or perceived to increase the likelihood of more quantitative easing (QE), stocks, currencies and commodities rise; when the news is bad, and/or there is less likelihood of QE those same markets fall and the money goes into U.S. Dollars. The U.S. Dollar is a risk barometer. 

Remember earlier I said what is cool about technical analysis is what the geometry of the individual chart is telling us. Let's look at a chart of the U.S. Dollar over the past year in Figure 2 and see what the pattern is?

Figure
Figure 2. Daily Chart of U.S. Dollar Index

The pattern for the U.S. Dollar on the chart is bullish. (Rule of thumb in determining a primary pattern: look at a years' worth of data, and the pattern won't have much room to hide).  The chart is bullish because of the pattern of higher lows and higher highs.  After looking at charts of both U.S. stocks and the Dollar we've determined that both charts are bullish. Yet we know that stocks represent risk on and the dollar represents risk off, and both charts are bullish? And it is the first week of May. 

Remember when I said: What is also cool about technical analysis is the study of correlations between related markets and what this is telling us about the business cycle and current Keynesian policies?  We are at a place now where the correlation may be yielding more valuable information than the individual markets. If risk on is long stocks, and risk off is long dollar and both charts are showing a bullish pattern, something is probably getting ready to give. The U.S. Dollar is telling us the risk to asset class markets is high, while asset class markets are telling us the business cycle is doing fine and Keynesian policies are working. 

So do we sell in May, and go away?  We might consider this more from the perspective of the currency market than the calendar. If the U.S. Dollar holds its bullish pattern, the currency and commodity markets which stocks are correlated to, are likely to go down.  If stocks rally, the greenback goes south, and the rest of the market rallies. Let's also remember the Keynesian policies. Earlier we said:  When global economic news is good, or perceived to increase the likelihood of more quantitative easing, stocks, currencies and commodities rise; when the news is bad, and/or there is less likelihood of quantitative easing, those same markets fall and the money goes into U.S. Dollars. Quantitative easing = Keynesian policies.  While you may be suffering from QE fatigue this past year, another symptom of analysis paralysis, we need to stay on top of that determinant, because the dollar chart is telling us that the Fed is indeed in the process of winding down its supportive - rate-easing -- actions.  This likely means we are closer to the training wheels being taken off of the bicycle, and the economy having to peddle up the hill on its own.  As a strategist the May date is another sprinkle of salt in favor of resurgent dollar and a stock market correction.  But I've come to similar conclusions in the past and been early - which is the same as being wrong.  But watch the dollar, and watch to see if Fed governors start sounding just a tad less in favoring of easing, even in the face of weakening economic numbers.  The recent Durable Goods numbers were bad, and advanced GDP dropped 0.8% to 2.2% from the previous quarter which is nearly a 40% decrease. And let's see if sell in May, and go away, makes it 4 out of the last 5 years.

Jay Norris is the Director of Forex Learning at IBUniversity.com and author of Mastering the Currency Market, McGraw-Hill, 2009 and Mastering Trade Selection and Management, McGraw-Hill, 2011.

Trading is a risky endeavor and not suitable for all investors! 

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