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VERSACE: Volatility brings opportunity for prepared investors

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OPINION/ANALYSIS:

While many people greet the month of May with an improving disposition as the spring weather brings cheery wishes of Happy May Day and Cinco de Mayo, investors both personal and professional tend to greet May with more caution. The adage most commonly associated with this month is "Sell in May and go away." This refers to the notion championed by Jeff Hirsch, editor of the "Stock Trader's Almanac," that stock returns lag in the summer months and that investors are better served investing in the November to April period.

This week's abrupt downdraft in the stock market has many wondering whether the adage will hold true once again. Before we delve into that, let's put some perspective around this adage. Mr. Hirsh's support for "sell in May and go away" centered on his findings from analyzing the Dow Jones Industrial Average (DJIA) from 1950 through 2008. Over that period, he found that it gained an average 7.3 percent for the November-through-April periods. By comparison, total returns during the May-through-October periods were barely positive, at 0.1 percent.

Now some raise a few red flags on this analysis, including the time period and the evolving socioeconomic landscape in the period. While that may or may not be as significant as some put forth, I personally think a broader measure of the stock market, economy and industry, such as the S&P 500 or the Wilshire 3000, would produce far better findings, compared with the 30 stocks that make up the DJIA. Again, this is my opinion. At the same time, Mr. Hirsh's summary findings are just that - the average of what happened over those months, which of course means there will be instances when May-through-October perform far better than the average as well as below it. As always, we need to dig deeper to get at the heart of the matter.

As I write this, the S&P 500 nears a 2 percent drop for the current May, which includes its worst two-session slide since February. Again some perspective on the month of May, and yes, for this I examined the S&P 500 so as to compare apples to apples. Over the past 20 years, May has produced a positive return of 1.8 percent on average, while in the past decade that return narrowed to 1 percent on average. Keep in mind, the last decade included the fall out form the dot-com boom, as well as the recent recession, but still on average, May has been a positive month for investors. The worst performance in the past 20 years for May was minus-3.1 percent in 2006 followed by minus-2.5 percent in 1999. Simple math would say that while it there might be some additional pain, the worst of the worst is over.

Is it?

Despite some favorable economic data this week that showed the burgeoning economic recovery continues, the stock market is focused on whether a Greek debt crisis will spread across Europe into Spain and Portugal. This is reflected in the upward move in the Chicago Board Option Exchange (CBOE) volatility index (VIX), which is widely considered the best gauge of fear in the market. On Tuesday of this week, the VIX spiked more than 20 percent to top 25, its highest level in almost two months.

As one would suspect, the upward move in volatility has prompted the rise of diverged opinions as to where the stock market is headed over the next several months. On the one hand, Standard & Poor's chief technical strategist, Mark Arbeter, recently shared his view that he expects markets to correct anywhere from 10 percent to 15 percent over the next six to 10 months with more damage in Europe and Asia than in the U.S.

By comparison, Neil Hennessy, portfolio manager and chief investment officer at Hennessy Funds, believes this is a "small-term correction" and that the DJIA will close 2010 near 11,800, or 8 percent higher from current levels. Mr. Hennessy acknowledges near-term fear, but puts forth the idea that the market will move higher as companies continue to deliver profit growth in the coming quarter.

As regular readers probably will guess, my thought is somewhat different. To begin with, I think it's very tricky to call the market as it is made up of too many industries, companies and moving pieces. As I suggested a few weeks ago, no one should feel badly about booking profits, and while a pull back in the market can be viewed as painful, particularly for those investors caught in the headlights, it potentially offers an opportunistic entry point for the prepared investor.

My preference is to focus on a smaller group of industries and companies that are benefiting from favorable trends and economic data. As I mentioned above, economic data this week continues to be favorable for the manufacturing sector, even though this week's initial jobless claims remain at lofty levels. In particular, new orders for factory goods rose 1.3 percent to $391.5 billion, the 11th increase in the past 12 months per the Commerce Department.

With that in mind, one strategy I favor would be to use any weakness in the overall stock market near-term to initiate or average down positions in those companies poised to benefit from the upswing in manufacturing - equipment, tooling and transportation companies spring to mind, and there are others as well. For those with a riskier appetite and want to place a bet that the overall market goes lower from here, you may want to examine some of the short exchange-traded funds (ETFs) like the Short Dow 30 and Short S&P 500 offered by ProShares, which offer short positions on the DJIA and the S&P 500, respectively. I would caution that shorting the market is risky as well as tricky, and therefore, is not for every investor, particularly those that have a lower risk profile.

My advice is be smart rather than reckless. Better to sharpen your pencil, do your homework and pick companies poised to benefit from favorable long-term trends and strike opportunistically. All the meanwhile, be sure to check your thesis and corroborating data points along the way.

Good hunting.

c Chris Versace is director of research at Think 20/20 LLC, an independent research and corporate access firm based in Reston, Va. He can be reached at cversace@washingtontimes .com. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.

About the Author
Chris Versace

Chris Versace

Chris Versace, the “Thematic Investor,” is the director of research at Think 20/20, an independent equity research and corporate access firm located in the Washington, D.C. area. Before Think 20/20, Mr. Versace was the portfolio manager of Agile Capital Management (ACM), a thematically driven alternative investment fund. The groundwork for ACM was laid during Mr. Versace’s tenure as senior vice president of equity ...

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