3 critical steps to take before Memorial Day

There’s an epic tug-of-war underway on Wall Street right now between bulls and bears, and it’s important for investors to keep tabs on the outcome.

The S&P 500 Index is up nearly 5 percent from its low last month. Both the S&P and the Dow Jones list of blue-chip stocks closed at new record highs on Monday and Tuesday. But not all stocks have fared so well.

In fact the tech-heavy Nasdaq and small-cap Russell 2000 Index have taken a real beating in recent weeks. The Nasdaq remains 5 percent below its high in March.

After robust gains in 2013, this year’s mixed messages are leading to increased volatility. An added concern is that, on top of all the recent turbulence, seasonal market trends just took a turn for the worse, which could mean even more volatility ahead.

Sell in May and Go Away?

We’ve all heard this phrase at one time or another. In fact, according to my colleague Jeffrey Hirsch, publisher of the esteemed Stock Trader’s Almanac, the phrase dates back to nineteenth century England.

Presumably, that’s when the aristocracy fled sultry London for cooler climates at their country estates, not returning until September. Today, this period encompasses the summer “holiday” season in Europe, when not much business gets transacted.

On this side of the Atlantic, Wall Street’s elite are also fond of fleeing the stifling concrete-canyons of Manhattan for cooler breezes in the Hamptons. It marks the summer doldrums for businesses and investors alike.

Likewise, this is the time of year when stock markets typically get choppy and underperform.

Analysts at Merrill Lynch crunched the numbers on the S&P 500 going all the way back to 1928 and found the May to October period is the weakest six-month stretch of the year for stocks, with average gains of just 1.9 percent.

Meanwhile, November through April is the strongest period for stocks, with the S&P 500 up 5.1 percent on average!

That’s a performance difference of nearly three-to-one between the two seasons.

Also, the risk of a 20 percent-plus correction is highest during the six-month period starting in May. This year also happens to be a mid-term election year, which has historically amplified the downside risk from May through October.

A little extra market volatility during the campaign season leading up to Election Day in November has resulted in an average decline of 2.2 percent for the S&P 500 during this period.

Given these statistics, it’s easy to see why investors might be eyeing the exits right now, before departing for an extended holiday at the beach!

But keep in mind; this cautionary tale of stock market seasonality does have a happy ending.

The chart below illustrates this seasonal pattern in stock market returns. As you can see, the good news is that we should be in store for a robust rally beginning later this year.

Click for larger version

If the pattern holds, we can expect a low for the S&P 500 sometime in the third or early fourth quarter, and a renewed uptrend in stocks into year-end!

Obviously, these seasonal trends don’t always repeat like clockwork, although it’s eerie just how closely the S&P 500 has followed this pattern so far in 2014. Also, I have seen these seasonal trends unfold many times before. So keep an eye on this pattern during the months ahead.

Does this mean you should sell before Memorial Day and go away from markets for the next six months? Well, not so fast!

Trying to overthink your timing of markets can be a big distraction, not to mention hazardous to your wealth. Jeff Hirsch points out: “The selling of everything implication and going away … is clearly imprudent at any time…” That’s especially true for long-term investors.

Instead, you should review your investment portfolio regularly. And right now, with markets choppy, is a good time to consider taking these three steps:

• Tighten any protective stops you have in place to help preserve open gains on existing positions and help side-step a steep decline.
• Hold your winning positions if you have a longer-term time horizon, especially those you believe have the best upside potential.
• Trim your underperforming investments to raise cash for better buying opportunities to come.

Summer stock market sell-offs are a lot like summertime rain squalls here in Florida … they appear violent during the downpour, but the sun soon shines again. Sooner or later this tug-of-war in the stock market will end, and we’ll see a well-defined trend develop, but I expect more volatility in the meantime.

Select high-quality stocks, both domestic and international, should perform quite well after this period of market turbulence ends. And if seasonal trends hold true, we should be in store for a wonderful opportunity to buy cream-of-the-crop, blue-chip companies at more attractive prices.

Good investing,

Mike Burnick