Sell in May But Stick Around
By Christian Thwaites
April 29, 2013
A bit odd, perhaps, to worry about deflation as the S&P hits all time highs. But the whiff of deflation is in the air. The YOY PCE core (the one the Fed likes) came in at 1.1% which is the lowest it has ever been. Here it is:
Source: Federal Reserve Bank of St. Louis, Economic Research
The PCE doesnâ€™t affect things likeÂ COLA. It has component differences to theÂ CPI, mostly in housing and medical. Its use as a policy tool is to separate out noise. Outright deflation tends not to occur much primarily because of wage and price stickiness, especially with leveraged companies. How? In theÂ firstÂ case, employees will take a 10% reduction in the workforce over a 10% reduction in wages. The clearing mechanism to lower wages can work through the labor market but takes time. And in theÂ secondÂ case, any company reducing prices to create demand puts immediate pressure on its P&L. Creditors then play rough on things like loan covenants. So that tends not to happen either.
The broad lesson is that deflation redistributes income from debtors, who have a high propensity to spend, to creditors, who donâ€™t. So demand falls. And if the wage stickiness persists, then real labor costs increase. Thatâ€™s why 2% deflation is a lot more pernicious than 2% inflation.
The central bankers know that and thatâ€™s why the Fed reaffirmed its commitment to QE citing â€śrestrainingâ€ť fiscal policy and â€śinflationâ€ť below target. A simple extrapolation of current inflation doesnâ€™t get us to the 2.5% target until...2021. Over at theÂ ECB, Draghi mentioned the ever so remote possibility of cutting the deposit facility rate. Sounds ok, except the rate is 0%. So negative rates? Heâ€™s clearly trying to push banks to lend more but for now excess money will just go into sovereign bonds. Surprise, Bunds rallied hard on the news.
So put these together, and we have worryingly low inflation, low demand and sub-par job growth. Any monetary stimulus will remain.
Everyone knows the â€śSell in Mayâ€ť rule. I originally heard (or misheard) the other half of it as "Buy again on Derby Day" (the British one) which is in June. But have also heard â€śBuy again on St. Leger Dayâ€ť which is in September. Either way, the link with horse racing and investing is clear. Does it work? The most often cited period of outperformance is October to April which returned 6.7% from 1942 to 2010 compared to 3.5% for long-term trend growth. Trouble is that record was pretty dismal from 1886 to 1942. Another period that works over the longer period is February to August which has a far more consistent, albeit smaller, return premium over long-term trends. These rules can work but experience tells us that the best advice is â€śSell in May, but be prepared to buy again at any time, and go away, but be prepared for a call back to your desk at any time.â€ť Which some people say is not quite as catchy.
Sources: Bloomberg; Capital Economics; Federal Reserve Bank of St. Louis; High Frequency Economics; Federal Reserve Board; ISI; Pantheon MacroEconomic Advisors; The Chart Store; ECB; â€śDeflation, the New Threat?â€ť Manmohan S. Kumar, IMF; Mainly Macro; Sentinel Asset Management, Inc.
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